Perhaps you have read some books or heard financial experts talk about “the magic of compound interest” where money rolled over again and again turns out into a pretty sum. The concept per se is actually quite good because it is true that keeping your portfolio’s principal and interest intact and re-investing them gains you much more in the long run, assuming you’ve put your investment in the right place.
The problem in the equation starts when certain financial gurus bring their interest assumptions to the table, say 9% or 15% per annum rate assumption. Using a perfectly crafted excel spreadsheet, the teacher drives home the point of enormous profits for the hardworking professional who compounds his money for say, ten or twenty years. Unless you are willing to settle for really mediocre returns, this assumption of evenly distributed returns does not really happen in the real world.
Take the case of mutual funds invested in stocks, for example. If you invested money at the height of the boom cycle late last year, your principal has most likely suffered a dent by now. Assuming a 10% to 15% annual interest rate would seem like wishful thinking. Should the market recover in one to two years time, then that may just provide an opportunity to recover your principal. The next bull market may allow great returns to offset the initial loss, but that can only be maximized if the investor really learned what it meant to time his investments or where to put his nest egg (like how to value investments – it’s easier said than done, actually).
In other words, the idea of compound interest cannot be overly simplified. It is not enough to tell people to invest their money and automatically expect growth. The young or new investor also needs to learn the entrepreneurial aspect of investing money. He also needs to develop a skill in determining which investments will have real value in the long run.
In one of Waren Buffett’s presentations during the Internet boom years, he showed a slide illustrating how the Dow Jones Industrial Average hardly went anywhere from December 1964 (874.12) to December 1981 (875.00).
In his authorized biography “The Snowball,” Alice Schroeder relates: “This meant, Buffett said, that the next seventeen years might not look much better than that long stretch from 1964 to 1981 when the Dow had gone exactly nowhere – that is, unless the market plummeted. “If I had to pick the most probable return over that period,” he said, “it would probably be six percent.” Yet a recent PaineWebber-Gallup poll had shown that investors expected stocks to return thirteen to twenty-two percent.” [p20 The Snowball]
Investing requires diligence on your part. The stock market or other business endeavors can provide enormous benefits if you take the time to understand how things work.
If you do decide to get a fund manager instead, like pooling your money in a common fund, just bear in mind that this arrangement automatically limits transparency. Although funds are usually professionally managed and even if periodic reports are submitted to the regulatory bodies, it will not be possible to see the exact details of how the money you invested is actually used. You will be provided a basic fund allocation table but unless you are the fund’s auditor, it would be hard to scrutinize each line in the income statement or balance sheet. In short, trust is a very important element when choosing a fund manager. Having a direct hand in your investments is always a critical question to consider.
All told, the ultimate decision on how much risk to take or where to put your money rests in you. You need to spend some time pencil pushing or crunching numbers, if only to protect your future stake. After all, it’s your money we’re talking about and no one can take your wealth away unless you allow it, either through ignorance or carelessness. Study and learn before it’s too late.