When looking at investment options, some financial advisors believe that compound interest should not be treated as a strategy in and of itself. We are not talking exclusively about advisors who emphasize conservative styles of investing; some of them will recommend adding cryptocurrencies to your portfolio, but they will also insist on making compound interest a pillar of your financial strategy.
Along with compound interest, other pillars of a financial strategy include money management, diversification of assets, and adequate risk tolerance. It is not unreasonable to say that compounding should be a fixture of money management. Let’s say you come across a $20,000 windfall through inheritance or the sale of a property; if you decide to use this cash towards getting started with investing, the rules of money management will tell you that the first step is setting up cash reserves.
Managing Your Capital
The process of figuring out cash reserves is simple. First, calculate how much you need to keep the household going for a month by adding up all expenses and necessities. This should include rent or mortgage payments, utilities, meals, household items, medications, tuition, and transportation. Multiply this times three in order to build an adequate cash reserve to use in case of a financial emergency; this money should always be kept in an account that can be easily accessed, and it could certainly be an account that earns compound interest. Cash reserves are strictly for emergency use, and you will need to work on replenishing them quickly if you happen to use them.
Once you have figured out your emergency cash reserves, you need to subtract them from your capital. In keeping with our $20,000 example above, let’s say your cash reserves come up to $6,000, which means that your investing capital will actually be $14,000. There is no need to keep these amounts separate as long as you know that $6,000 will be untouchable unless an emergency arises.
Investing Your Capital
Now that we have established compound interest as the basis of your personal investing strategy, we can turn our attention toward risk tolerance and diversifying your portfolio. As previously mentioned, just about any investment you can think of can be boosted through compounding, but you should look for those that are more likely to yield periodic gains instead of rapidly losing value through speculation or volatility.
Starting with the $6,000 emergency cash reserve fund, your best bet will be to deposit it in a high-yield savings or a money market account. These two financial instruments automatically reinvest the interest earned, and their penalties for early withdrawal are minimal; plus, banks that offer these accounts typically make funds available on the spot, thus making them adequate for emergencies.
If you are a conservative investor, the following investments are highly recommended for compounding:
- Certificates of deposit: With these instruments, your money will be tied up for the contracted term, but the interest paid is definitely worth the wait. The risk involved with CDs is minimal.
- 401(K) and IRA plans: Not all retirement plans with a 401(k) designation offer compounding, but quite a few of them do, and they are the ones you should look at. Most IRAs will compound on an annual basis. Keep in mind that retirement plans are meant to be long-term commitments that require you to contribute by means of payroll deductions.
- Bonds: Unlike the instruments listed before, corporate, municipal, or sovereign bonds do not compound automatically. It will be up to you to deposit interest payments in a compounding account, but there is a smarter option. Mutual funds that focus on a bond portfolio offer compounding as a client option, so you will simply need to “turn it on.”
If your risk tolerance is higher, you may be able to capitalize on your compounding strategy faster with the following investments:
- Blue-chip dividend stocks: Wall Street giants such as Coca-Cola, IBM, and Walmart have an excellent track record of value appreciation that translates into nicer dividends. A practical way of investing in these stocks is through the ProShares S&P 500 Aristocrats, which is an exchange-traded fund that tracks the average performance of major dividend providers. This ETF trades under the NOBL symbol, and it has been posting impressive growth since March 2020.
- Rental property: Returns generated by lease agreements can be quite lucrative in the right housing market. San Francisco, Manhattan, and South Florida are examples of regional markets where landlords have been cashing in over the last few years. One of the problems with this strategy is that landlords would need easy access to the cash they can use for maintenance purposes and miscellaneous expenses.
- Real estate investment trusts: If you wish to eliminate the burdens of property ownership while still benefiting from its intrinsic value, REITs can be great options because most of them are managed by teams that trust in the power of compounding. Many REITs pay dividends to shareholders; in fact, they use them for the purpose of staying competitive and attracting more investors.
Getting the Most From Your Compound Interest Investment Options
It is critical to understand that the gains generated from compound interest are meant for passive accumulation. After all, compound interest is really just an illustration of compound growth and will eventually work to its advantage, but only if you stick to a disciplined rate of contributions. This is how legendary investor Warren Buffett attained his personal wealth; he has never stopped depositing as much as possible into his compounding portfolio. If you are locked into a good job where you feel secure, you may want to review your IRA or 401(k) and see if your contributions can be increased.
You will always be better off holding a diversified portfolio with the power of compound interest than trying to predict which direction the asset will move. Since investing strategies need to be reviewed regularly in order to make changes in the portfolio, this approach takes time. The numbers given by our compound interest calculators do not lie because they are based on a simple logarithm.
Please feel free to play around with our daily compounding calculator, particularly with regard to increasing the amount and frequency of your contributions. To make things even more interesting, you can always set personal challenges in this regard; for example, if you are contributing $100 per month now, think about increasing it to $120 starting next month and $150 after the holidays.