NEW YORK (TheStreet) — There was a time when compound interest was all investors needed to make their money grow.
These days, compound interest doesn’t even give your money a light cardio workout. For those tired of watching their hard-earned money sit in savings and checking accounts and other low-yielding vehicles, compound interest can be helpful, but it doesn’t provide all the answers.
“Compound interest is nothing more than reinvesting your interest in any investment vehicle,” says Barry Zischang, Certified Financial Planner and Vice President, Wealth/Estate Strategies Advisor and high net worth in RBC Wealth Management’s Micera investment group. “Essentially, you earn interest on your interest over a period of time. Instead of withdrawing your money and investing it in something else or spending it elsewhere, you reinvest it and let it grow on a compounded basis over time.
For compound interest to work, you need a little initial investment and time. However, with low interest rates, reinvesting dividends in stocks that provide a dividend can generate far greater growth than compounding interest.
“Capitalization is one of the biggest things in finance in terms of investing in general,” says Mike Sorrentino, CFA and chief strategist at Global private finance capital. “It’s a snowball effect in which the first few years of not so impressive returns – 4%, 5% or 6% – may not excite an investor, but as you go down the line it turns into real earnings.”
How long? Sorrentino and Zischang suggest that investors use the Rule of 72 to understand how fast the composition can work. If investors take their rate and divide it by the number 72, that should give them a rough estimate of how many years it will take them to double their money with a single investment.
If your investment has an average annual growth rate of 6%, the rule of 72 indicates that it takes about a dozen years for this investment to double.
“When you talk about capitalization, you have to have a long-term time horizon,” says Sorrentino. “You only really see the benefits of compound interest between 9 and 15 years.”
Although people close to retirement age may not have time to benefit from capitalization, it can be a great help for young investors looking for the fastest ways to build up. a nest egg. Sorrentino and Zischang touched on a few options for investors and we listed them from most effective to least effective:
Yes, stocks are volatile and carry some risk, but remember that compounding is a long-term proposition. Investing well in stocks has some distinct advantages.
“A lot of people consider stocks to be high risk, and they can be, but over the long term they’ve been the best performing asset class,” Sorrentino said. “The long-term average annual return on stocks is about 10%. According to the rule of 72, you’ll double your money in 7.2 years on average with stocks or any index fund.”
Plus, off-peak times aren’t necessarily a bad thing. Zischang notes that one of the benefits of the compound effect is that you always reinvest at the price at the time of reinvestment. If you are in a low year, you buy stocks at this low price. Sticking to equities gives equities time to recover from a change in interest rates, a bad jobs report, or any other news that causes a short-term investment to react. By continuing to reinvest, you take advantage of falling prices to reinvest a little at a discount.
Even if you dip your toe into stocks by investing in a working 401(k) or Individual Retirement Account A, there’s a good chance you’ll come out on top if you stick with it for the long haul. Since 1980, the value of shares on the S&P500 increased by 1800%. This includes several recessions, the turn of the century dot com bustthe recent financial crisis, Bernie Madoff, Enron and all the rest.
“We may not see incredible growth like we have for the past 30 to 40 years and the new normal could be slower growth going forward,” Sorrentino said. “But even if 10% stock return turns into 7% stock return, compound interest will still pay you back.”
exchange traded funds
Welcome to ETFs. Representative of many different types of assets, from bonds and treasuries to stocks, ETFs exist in different forms for different asset classes, risk profiles and returns. Many pay a dividend that investors can put back directly into the ETF, but they also tend to require a little maintenance.
“ETFs available these days are highly liquid and less expensive than your typical mutual funds,” says Sorrentino. “Whether it’s a bond ETF or an income-generating ETF, any income it produces will need to be reinvested into that fund in order to reap the benefits of compounding. If you go with the ETF, you have to reinvest those dividends or you’ll just have that static principal.”
Due to the makeup of ETFs, however, they can be a bit volatile. There will be years when the ETF loses money, but this volatility should not be reduced to outright risk. Investors can play it safe by investing in Global ETFs and diversify their holdings by type and region, but Sorrentino says the most important thing investors need to do with their ETFs is be patient.
“You’re going to see a few recessions, but the average investor doesn’t have time to go in and manage those accounts,” he says. “Equity ETFs are good, but you have to give them time to develop.”
By combining a variety of different assets, including stocks and bonds, mutual funds offer a bit of diversity for people who want to reinvest their dividends and capital gains back into the fund. That said, mutual funds are also problematic.
“I’m not a big fan of mutual funds,” says Sorrentino. “I think their fees are a little high and they’re a little twisted on taxes.”
US Savings Bonds
“Usually you buy them at a certain price and they will mature at a guaranteed level in the future,” says Zischang. “These also give you the benefit of compound interest with the added benefit of tax deferral.”
That said, it takes time. Sorrentino points out that people who invest in US savings bonds lock themselves into 2.5% annual gains for the next 30 years. He sees that gain being overtaken by inflation at some point, but notes that the Fed’s interest in raising interest rates will make bonds less safe haven than they have been in recent years.
“There’s this idea that bonds are a safe investment, and they’re not,” Sorrentino says. “Bonds have gone up over the past 30 years because interest rates have been falling all the time. Try to manage a bond portfolio in a rising interest rate environment.”
Certificates of deposit
For many years, the classic compound interest product was the good old CDthe emphasis on “old”.
“The FDIC-insured certificate of deposit would provide you with a standard interest rate over a specific period of time, and your interest would accrue over that period of time,” Zischang says. “Of course, when interest rates were higher, it was great. It was a great way for investors, newbies or not, to take advantage of the benefits of compound interest.
Unfortunately, prices on a CD haven’t been great for a long time. Current CD rates fluctuate between 0.2% and 1.2%, which is not very good considering that the inflation rate in 2014 was 1.6%. By locking in those low rates, Sorrentino says investors are locking in a loss of purchasing power. While the Federal Reserve has been making noise to raise interest rates, Sorrentino notes that it took interest rates nearly two decades to recover from the Great Depression and more than three decades to reach their previous peak. .
“A potential investor who is extremely risk averse asked me when the Fed’s interest rate hike would translate into getting 5% of a bank CD,” he says. “I have this conversation once a week: The days of 5% bank CDs are over and they’re not coming back in our lifetime.”
This article is the commentary of an independent contributor. At the time of publication, the author had no position in the stocks mentioned.