What is Compound Interest (Part 2)
In the last post, we discussed interest payments, and alluded to how compound interest can build vast amounts of wealth if your time horizon is long enough. In this post we will investigate simple vs compound interest, and show the massive impact compounding can provide.
How do we actually get those compounded returns?
Where to Invest to Get Compound Interest?
This is a question with an easy and impossible answer. The easy answer is to go set up a brokerage account (an account that will allow you to invest in a variety of things). A brokerage account will allow you to buy stocks, bonds, metals, etc., but it will be up to you to choose the investments. We encourage you to check out our archives for blog posts on specific investment products so that you can have a better understanding of each.
Since there are pros and cons to each, it's important to understand what each product offers.
The point is, you will need to invest something (money or time) to get a return on that investment. Otherwise, there can be no return to compound.
Naturally, this of course begs the (literal) million dollar question...
What are the best investments with compound interest?
And now we come to a debate that has been raging since the time of trading bananas for goats. If there are risks and benefits to each, which is the best investment in terms of risk vs. reward? There are as many answers as there are investors.
For some, the stock market as a whole is the best investment for getting returns on capital. Others will argue that it’s the bond market. Gold bugs will say that a safe full of gold is the best investment.. Some people invest in priceless Picassos. Many people think owning land and other real estate makes the most sense.
Though the answers are varied, none of them are incorrect. We personally think that avoiding drawdowns while maximizing positive returns is the best way to compound wealth. We offer a separately managed account solution that does just that.
Bottom line, any investment that has a return that you can reinvest is a good candidate for compounding interest.
Linear Growth vs Exponential Growth
If you missed the overall simple vs. compound interest explanation, I’d encourage you to take a look at our previous blog post outlining the basics.
When looking at a return profile involving compounded returns vs. simple returns, you’ll notice that one is a parabola (an exponential curve), and one is a line. Take a look:
Which return profile would you prefer? The orange line continues curving up until it's almost a straight vertical, which translates into ridiculous returns. Love it or hate it, this is how the 1% accumulate and continue to accumulate wealth. This is a perfect visual explanation of the power of compound interest.
The value of 1% compounded
While talking compound interest, it can’t be stressed hard enough that the difference between a 5% return and a 6% return is ENORMOUS in the long run. One or two percentage points will translate to TENS or HUNDREDS of MILLIONS of dollars over a long enough investing timeline.
This is why your returns need to be as high as possible and as stable as possible. High returns compounded without large drawdowns can lead to massive returns that, when compounded, lead to tremendous wealth generation.
Take a typical 30 year time horizon:
5% return over 30 years:
432% return in total - not bad!
6% return over 30 years:
574% return (+132% difference!)
7% return over 30 years:
762% return (+ 330% difference!)
10% return over 30 years:
1,744% return!, This is 4 TIMES the return as 5% (!!!)
15% return over 30 years:
6,621% return!!! That is 16 TIMES the return as 5% (!!!)
As you can see, the difference between a 5% return and a 10% return is a multiple of 4x. If you were going to retire at 65 with a target of $1 million in savings, if you could increase your returns by a SINGLE percentage point, you have an extra $132k to use on whatever you please! Maybe you could leave it to your children with strict instructions to let it go for another 20 years to earn a huge multiple of the original bonus value. Or maybe you buy a nice boat. It's nice to have options.