Friday, January 15, 2021

What Investors Often Get Wrong About Compound Interest

Given the close relationship between finance and mathematics, you would think that investing would be an activity that can be explained by numerical proofs and hard facts; quite often, however, this is not the case. Investing is actually closer to behavioral psychology than to mathematics, which means that we cannot reasonably compare it to “hard science.”

Common Myths and Misunderstandings

The world of investments is filled with conjectures, assumptions, and myths. The reason investing is less than scientific it is fueled by human hopes and speculation. What this means for financial strategies such as compound interest investing is that it is not impervious to myths and half-truths. The most oft-mentioned myth about compounding is that Albert Einstein was once quoted as saying that compound interest is the eighth wonder of the world. Historians and biographers who have studied Einstein agree that he was fond of compound interest investments, but it is unlikely that he ever spoke about the topic with such passion.

Another myth associated with compounding is created by prospective investors who evaluate it purely as a mathematical constant. Many financial planners like to present the rule of 72 along with compound interest calculations to illustrate the advantages of this financial strategy, but they also use annual rates of return between 7% and 10%, which any seasoned Wall Street investor will tell you are very difficult to achieve on a constant basis.

The real power of compound interest can only be unleashed with disciplined contributions

Compounding myths are easy to dispel with reality, especially the tall tale about just sitting back and letting the money in your portfolio grow while you do nothing. The real power of compound interest can only be unleashed with disciplined contributions to your portfolio. If you commit to setting up a $200 debit from your checking account to be transferred into your compounding portfolio every month, you will begin to see the magic of this strategy a few years down the line. If this contribution comes from your paycheck, you can’t say that you are just kicking back and letting money grow like a tree; these are funds you earned through your work or line of business. The longer you are able to reinvest your earnings in a compounding account, the more you will get out of it.

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