When reading about personal finance topics such as compound interest investing, you are bound to see the term “rational investing” being mentioned a few times. When economists make microeconomic projections, they assume that most investors are rational, which means that they make decisions that ultimately make sense. Compound interest is part of a rational investing strategy because it seeks to reinvest guaranteed profits.
The Qualities of Rational Investing
The rational descriptor of rational investing refers to behavior. A rational investment is the kind that can bring about a certain benefit without too much risk; for example, purchasing certificates of deposit from a reputable bank and placing them into a compounding portfolio. An irrational investment would be to borrow money in order to place an underdog bet on the Super Bowl.
An important principle to follow is known as money management
We can safely describe rational investing as a collection of principles. An important principle to follow is known as money management, whereby you only invest what you can reasonably afford to lose. If you have $100 leftover after paying all of your bills and household expenses, proper money management would dictate that you take those $100 and start building up to three months’ worth of household expenses as cash reserves; you should not start investing until you have managed to save up this emergency fund.
Good Investment Principles
Another rational investing principle you should know is called the time value of money. In essence, this principle tells you that the money you earn today will be worth less tomorrow because that is the way inflation works; in other words, money is always more valuable in the present.
stuffing money under the mattress is a terrible idea
You may not immediately realize that compound interest investing automatically takes into account the time value of money, thus hedging you from the reality of your money being less valuable in the future. This is the reason why stuffing money under the mattress is a terrible idea; all the same, putting your money into a simple interest savings account will not do you any favors. On a long enough timeline, the money you hold today will be worth zero unless it is reinvesting earnings such as in a compound interest portfolio.