Wednesday, March 3, 2021

Compound Interest vs. Wall Street: The Real Difference

Here’s a question that many investing rookies often ponder: If compound interest is such a great financial strategy to follow, why do Wall Street investors even bother to risk their capital on trading equity securities? The answer is not so simple because the bottom lines can be similar for compounding and stock portfolios as long as you view both through the lens of long timelines. The easiest way to understand why compound interest investors will invariably come out ahead boils down to risk.

Guaranteed Returns & Long-Term Investing

Everyone can understand that earning interest on interest will lead to exponential growth, but in order to make this calculation work, we need guaranteed returns. Savings accounts and certificates of deposit are examples of financial instruments that can guarantee returns in the form of fixed rates of interest, but this is not the case with stocks. You have to keep in mind that stocks are expected to rise along with company valuation, and this cannot be guaranteed.

only when we compare across decades

When making comparisons between compounding and Wall Street benchmark indices such as the Dow Jones Industrial Average (DJIA), it does not take long to see that stock investing can be more profitable than compound interest, but only when we compare across decades. If we focus solely on preferred stocks that pay out dividends, which we can reinvest in order to buy more shares, we will likely see Wall Street coming out ahead. Please note that the DJIA is a representation of Wall Street as a market; things are certainly different when the comparison involves a single stock over a shorter timeline.

there are no guarantees or reassurances on Wall Street

All stock investors know that their portfolios can lose value; there are no guarantees or reassurances on Wall Street. Since 2012 or so, those who invested in stocks that track market indices such as the DJIA and the S&P 500 have enjoyed great success notwithstanding the turbulent markets roiled by the coronavirus pandemic, but there is nothing that can warrant a continuance of this exponential growth. Compound interest investors whose portfolios are filled with conservative instruments do not have to worry about market conditions because their returns are written in stone and calculated by a logarithmic function; therein lies the difference.

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