A Myth That Compounds Way Faster Than Your Money!

For years, investors have been told a myth of sorts. That if they leave their money invested in the market, compounding will work it’s magic. Unfortunately, the experts left our part of the equation - which we’ll get to shortly. Compounding, a concept largely derived from how cash sitting in a bank grows, does not work the same way. Per Investopedia.com

Compound interest (or compounding interest) is interest calculated on the initial principal and also on the accumulated interest of previous periods of a deposit or loan. Thought to have originated in 17th-century Italy, compound interest can be thought of as “interest on interest,” and will make a sum grow at a faster rate than simple interest, which is calculated only on the principal amount. The rate at which compound interest accrues depends on the frequency of compounding; the higher the number of compounding periods, the greater the compound interest. Thus, the amount of compound interest accrued on $100 compounded at 10% annually will be lower than that on $100 compounded at 5% semi-annually over the same time period.

The KEY: COMPOUNDING only works for you if you avoid DRAWDOWNS!

The table to the left compares two different but similar scenarios. In scenario 1, two years of 10% gains are followed by a 10% loss and the pattern is repeated. In scenario 2, money compounds at a consistent rate of return (3.3%)

What you will notice is that scenario 2 is the winner. The tortoise beat the hare. In scenario 2, despite modest returns, the principal has grown 21.72% (in 6 years) and in the other example, despite there being 4 of 6 years at a 10% return, the unlucky investor would have less money. Scenario 2 has no drawdowns!

The moral of the story is what many investors miss! Scenario 2 is better. Compounding is working. Slower growth is winning because big drawdowns are being avoided. This is how compounding works!

That's just the way it works!

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Darryl Rosen MBA, RICP

Darryl Rosen is the founder of Rose Advisory Group, and operates www.RealRetirementAdvice.com as a way to help others create their ideal retirement. He is obsessed with helping people create safety, simplicity and strength in their financial future. Darryl’s clients enjoy his straight-forward, plain-spoken guidance, strategies to minimize taxes and ability to generate investment returns, while minimizing risk so his clients can sleep at night! Darryl is licensed to provide guidance on securities and insurance solutions and has achieved the highly desired Retirement Income Certified Professional (RICP) designation.

Darryl is the creator of the well-known SECURiMENT™ Retirement Planning Method. A simple to understand and implement planning method that demystifies retirement planning so that people can take action. Visit Rose Advisory Group to learn more! 

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