Compound Interest

By now, you may have noticed that many of my previous posts are gone. This is because I received some feedback that previous posts were too complex. Today’s post, like other posts made this month, attempt to explain more basic concepts. Today’s subject is compound interest. 

Compound interest is amazing. Why? Because the rate of growth is ever increasing. It’s the equivalent of a snowball rolling down a hill – its gets bigger and bigger and bigger.

With compound interest, your investment will grow at an exponential rate. Since compound interest grows on top of previous growth, time is the friend of compound interest. With compound interest, a little extra time is reward with substantially more return. The more time, the greater the growth.

Consider a hypothetical example. With compound interest, one dollars invested at a 20% interest rate will grow to $5 in 10 years. That’s amazing. But if you give that $1 another 10 years, you’ll have $32. That’s incredible. If you add another 10 years, that $1 is now worth $198. Wow! Just ten more years will produce a return of $1,225. That's outrageous.



Look at the chart below to see just how much more value time can add exponentially.

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How does this happen? Compound interest works because the principal (the $1 invested) not only produces interest, but the total of all interest produced also produces more interest. So, while in the first year you have $1 working for you, you have $5 working for you after 10 years. By getting your money to work for you, the effect is exponential.

In short, save as much money as you possibly can and invest it today!

What the Fed is Going On?

If you’ve taken a look at the stock market recently, you’ll notice some poor performance. This is because investors are afraid of the Federal Reserve’s (the Fed) change in policy. The Federal Reserve is a private bank that essentially sets the interest rate. The Fed is the reason why your savings account is paying nothing, and also why the stock market recently reached an all-time high. In fact, these two events are related.

 

In the wake of the recent sub-prime crisis, the Fed lowered interest rates to stimulate the economy. Investors reacted. Since interest rates in savings account were low, some investors moved their money into other assets, assets they hoped would generate a higher investment return: specifically stocks. This increased demand for stocks drove up stock prices, creating the all-time market high. In short, stock prices have been artificially inflated because of low interest rates.

In previous posts, correlation was discussed. Consider how interest rates are correlated with stock valuation. As interest rates decline, stock prices shoot up – resulting in over-valued securities.

Now, the Fed made the announcement recently that it will be reversing course – that is, raising interest rates. With higher anticipated interest rates, those temporal stock market investors have made the decision that their money is better off in a savings account – which eventually should be paying a higher interest rate than what is being offered right now.

 How much will the market decline? This depends upon the Fed’s next move – how much interest rates rise.

What does this mean for the investor? Expect a market decline in the short-term.

MPT & Correlation

Last time we discussed correlation, with respect to weight training with fat pugs. Delving deeper into the subject, correlation is the extent to which one asset’s performance mimics another asset’s performance. The following line graph illustrates correlation.  Consider how the performance (investment return) of the S&P 500, in blue, is highly correlated to the performance of international companies, in purple. The blue and purple lines rise and fall in value simultaneously. When blue is up, purple is up. When blue is down, purple is down. Thus, the performance of domestic equities (blue) and international equities (purple) are highly correlated. 

As mentioned in the previous post, long-term Treasuries are negatively correlated to the S&P 500. The red line (long-term Treasuries) makes the opposite change in value relative the blue line (the S&P 500). When blue is up, red is down. When blue is down, red is up. 

In the chart above, commodities (oil & gas, precious metals, etc.) exhibit little relationship to the other asset classes just mentioned. Consider how the green line (commodities) rises and falls relatively independently of the other asset classes.

According to Modern Portfolio Theory (MPT), a portfolio of investments functions best when it is diversified among assets that have low, no, or even negative correlation to each other. Since every asset suffers from periods of poor performance, and since every asset worth investing in grows over time, diversification across uncorrelated asset classes will ensure consistent portfolio growth.

Lastly consider that Modern Portfolio Theory is just that - a theory. While some investors swear by its risk reduction properties, others dismiss it - with some preferring a strategy of value investing. In future posts, value investing will be explained, especially with respect to its pros and cons over Modern Portfolio Theory.