Wednesday, March 21, 2012

The Miracle of Compounding Interest

It is often surprising how few people understand the power of compounding interest.  It is a powerful thing.  A lot of investment companies will sell their products by giving you examples of compounding interest.  For example, if you invest $10,000, just one time, at the age of 20 and earn a return of 6% every year, you will have over $137,000 by the time you reach age 65.

It is called compounding interest, but "interest" just refers to the rate of return.  You can make your return by earning dividends or capital gains and it doesn't have to be with stocks.

While it is a lot harder these days to get a decent and consistent return on your money, compounding interest is still important, especially if you are relatively young.  You don't need a lot of money to start building a portfolio.  It may seem small at the start, but if you stay with your plan and you keep contributing money, even in small amounts, it can add up to a big sum later on in life.

I think one of the best things to look at right now is real estate.  In many places in the U.S., houses have fallen 50% or more in price.  In many places, you can buy a house with 20% down and actually get positive cash flow.  You will get a return on your money every month (assuming no major repairs).  Plus, you will be slowly paying down the mortgage.  Plus, you might even get capital gains one day on the price if the housing market recovers.  While houses may or may not go up in real terms, monetary inflation is likely to eventually drive the nominal prices higher.  Meanwhile, you can pay off (or your tenants can pay off) your fixed-rate mortgage with depreciating money.

Outside of real estate, I advocate that you invest in something like the permanent portfolio as described in Harry Browne's book Fail Safe Investing.  It is the best thing I know of that will allow you to sleep at night.  It has been quite consistent in providing good solid returns above the inflation rate.

Tomorrow, I am going to continue on this subject of compounding interest, but instead of applying it to individual investors, I am going to apply it to civilizations.

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