The Myth of Compounding Interest
Editor’s note: It’s one of the oldest rules of saving and investing: the wonders of compound interest. But can you rely upon it to build wealth? Today eccentric former hedge fund manager gives you his surprising answer.
Albert Einstein supposedly said, “The eighth wonder of the world is compound interest.”
The idea is that if you put some money in the bank and let it sit there or invest it wisely, it will somehow “compound” into millions of dollars by the time you need it. At first take, it does sound somewhat wondrous.
This quote has been the underpinning of many books, shows, marketing campaigns and myths about personal finance for years. Too bad it’s total nonsense — and a myth that’s cost people millions of dollars.
First off, Einstein never said it. In 1983 The New York Times claimed that he did, but nowhere else before that (and he died in 1955) is there evidence he said it.
However, Johnny Carson said something about compound interest on The Tonight Show in the early ’80s that is very real and very true. He said, “Scientists have developed a powerful new weapon that destroys people but leaves buildings standing — it’s called the 17% interest rate.”
In other words, saving money is all fine and good. But when inflation hits and financial meltdowns happen and you’re in debt, chances are your money hasn’t compounded enough to help you when you most need the money.
Right now, in July 2019, the average interest rate being paid on “high-yield” savings accounts in the United States is nothing. (And don’t even talk to me about savings accounts at your typical bank.)
Worst of all, even the miniscule yields are often quoted in terms of annual percentage yield, which takes compounding over the course of the year into account, meaning the true interest rate paid is even less.
There are stories about some janitor who dies and it turns out he had $90 million saved up because he invested in Exxon in 1950 and he reinvested the dividends, etc. Maybe one or two of those stories are true, but that is not the norm.
Those anecdotes are mostly just used in commercials by people who want to capture your fees to build their own businesses, not because they’re inherently true.
First off, inflation is always going to rise faster than the value of money left in a savings account. There’s rarely been a period when that didn’t happen (the Great Depression and early 2009 are the only examples I can think of).
Second, nobody can merely reinvest his or her way to wealth, not even Warren Buffett. Warren Buffett is a legendary investor and has plenty of success to show for it, but the initial part of his wealth came from the fees he charged on his hedge fund and the money people put into his insurance companies. Then he invested those funds and kept 100% of the profits.
It wasn’t just reinvestment that pushed him into the realm of the billionaires.
So compounding, by itself, will never make you rich. The argument for saving money is that it then begins to work for you. But there are much better ways for your money to work for you than compound interest, which is the fool’s gold found at the end of a rainbow. You can chase after it but you’ll never find it.
Smart, value-driven investing is one part of the answer, and for the clearest example of this just look at Warren Buffett again.
He may not have compounded/reinvested his way to great wealth, but his value investing style has certainly helped him maintain and grow this wealth over time.
Buffett’s investment rules are famous. Rule 1: Never lose money. Rule 2: Never forget Rule 1.
This means that, as an investor, Buffett first finds out how much he might lose on a stake in a worst-case scenario, and once he’s satisfied with that, he looks at the potential upside. He’s obsessed with playing defense, not offense, because he knows that losses are far more common in the market than gains.
Paul Tudor Jones, another billionaire investor, is the same way. He’s more of a short-term trader than Buffett (and me), but has said time and again in interviews that as an investor, he is focused almost entirely on not losing money. On playing defense.
Not only does focusing on the risk involved in market moves help with capital preservation, but it frees up these investors to make smarter and sometimes bolder moves with their money. To reach for bigger returns when they know that they’re operating on solid ground.
And that’s something that everyday investors can learn from as well.
for The Daily Reckoning