“Invest early and often because of the power of compound interest!” I can’t tell you how many times I’ve heard financial “experts”, financial advisors, and popular blogs say this. However, when it comes to your money, there are two really important myths about compound interest that you need to know.
In this article I define what compound interest is, detail what is more important than compound interest, provide 2 myths about compound interest, and answer a few common questions we get.
Most Importantly, I detail why your focus should be on compound growth not compound interest.
How Do You Make Money With Compound Interest?
Compounding interest means you invest money and you earn interest on it today. Then tomorrow you earn interest on the money you originally invested plus the interest you earned yesterday. Overtime, the interest compounds and your assets grow tremendously.
For example, if you invest $10,000 and you earn an annual interest rate of 7%, then after one day you’d have $10,001.92. Then on day two you would earn an annualized rate of 7% on $10,001.92.
If you did this continuously for 30 years you would have $81,645. People say to invest early and often because if you waited to invest the $10k for 10 years (i.e. it only grew for 20 years instead of 30) you’d have $40,546.
Obviously, we’d all want more money. However, blindly saying “Invest early and often because of the power of compound interest” leads to 2 big myths that can cost people a lot of money.
Compounding Isn’t The Key To Financial Freedom When Financial Planning
When I first started my journey to financial freedom, I thought compounding is all I needed. However, as I built the technologies that I eventually would use as the foundation of our financial planning technology at FitBUX, I realized compounding interest by itself.
There was something even more important to achieving freedom.
In our financial freedom webinar, I discuss the 3 categories we should organize our money into. They are day-to-day money, money for future self, and risk management.
Most of us start with about 60% of our income going to day-to-day money and only about 20% going to money for future self.
As are income goes up those figures never change. Instead life style creep sets in.
You should be trying to increase money to future self over-time.
If you don’t, you will be compounding returns but it will never be enough for you to become financially free.
Myth #1: Compound Interest & Investing Early Always Gives You More Money
This is an absolute myth because it fails to take into account your individual situation. Specifically, this isn’t true if you have debt.
The reason being is that when you have debt compounding interest is in effect. However, its working in favor of your lender which in turn means its working against you.
Therefore, if you have student loan debt at 6.2% and you earn less interest than that on a risk-free investment, investing early and often for compound interest actually puts you in a worse position than paying off your loans and investing afterwards.
I take a much deeper dive into this myth in this article: Pay Off Student Loans Or Invest: 7 Steps To Decide What Is Right For You.
The important aspect to remember in this article about this myth is to focus on compound growth which incorporates debt. Another word or way to look at compound growth is net wealth. You want to do your best to compound your net wealth over time.
Myth #2: Invest In The Stock Market Because Compounding Interest
One of my biggest pet peeves is when I hear one of the following statements or some type of derivation of the following:
- A financial advisor I spoke with recommended I invest early and often in the stock market because of compounding interest.
- A blog I read said that I should invest in 401k, IRA, or Roth IRA to take advantage of compounding interest.
If you ever hear a financial advisor say this, kindly thank them for their time and run. If you ever read a blog that says this, I recommend not reading it anymore. The individual saying this clearly has no idea what they are talking about.
What do I mean??? Stocks do not pay interest. Fixed income investments (such as bonds), pay interest.
Therefore, when someone tells you the stock market makes 7% per year and compounding that interest will benefit you… they are leading you down a potentially bad path.
Let’s examine this further and how it plays a roll with you investment.
Stocks pay dividends, not interest. When an advisor is quoting a 7% return on the stock market, most do not realize that a super majority of that return is from dividend reinvestment.
Therefore, logic would say to invest in stocks that pay higher dividends. However, advisors will often look at your age and say, “You are young. Therefore, you should take more risk.”
More risk in the stock market means focusing on investments that don’t pay dividends (or pay a low amount of dividends). Therefore, the only way to “compound growth” is to buy and sale investments at the right time. Trying to time the stock market is one of the worst ideas you can have. Especially in accounts such as a 401k or IRA.
This is really important to understand for 401ks. Most default to target date funds which are based on your age. Therefore, they tend to put more of your money in higher risk investments. Translation, target date funds have investments that don’t pay dividends or pay a low amount of dividends.
Therefore, you should have more weight to fixed income investments and dividend paying investments than what you have in those target date funds.
On top of this, retirement accounts are tax deferred. Therefore, you can reinvest 100% of the dividend you receive from stocks and 100% of the interest you receive from fixed income investments. If you are going to hold “more risky” investments do so in taxable accounts so you can take advantage of capital gains tax laws.
2 Common Questions
Below are two common questions our FitBUX Coaches get about compound interest that you may have as well.
Do Investments Compound Interest?
Fixed income investments do. For example, bank CDs, treasuries, and bonds. Stocks do not pay interest, they pay dividends
Does My 401k and/or IRA Compound Interest?
No, a 401k or IRA is just a holding vehicle. You have to select the investment within it. The investment may then compound interest. However, a 401k or IRA by itself does not.
One caveat to this is that the money you put into the investment may be put into a “cash” account until you select the investment. The cash account pays interest but at an extremely low rate.
Compound interest is awesome. However, blindly putting money into investments without a good financial plan will do very little for you.
As stated above, increasing money to your future self over time is more important than the effects of compound interest.
If you need help developing a plan to do this, the technology at FitBUX is designed specifically with that goal in mind. Become a member, build your financial plan, and if you have questions be sure to schedule a call with one of our FitBUX Coaches.
I have a question about this paragraph – “This is really important to understand for 401ks. Most default to target date investments which are based on your age. Therefore, they tend to put more of your money in higher risk investments. Translation, target date funds have investments that don’t pay dividends or pay a low amount of dividends. Therefore, you should have more weight to fixed income investments and dividend paying investments than what you have in those target date funds.”
Are you saying that regardless of age, high dividend funds are the best option? Or that there should be a balance? You haven’t outlined in detail the difference in behavior between how dividend funds grow in 401ks vs standard brokerage accounts.
Can you please add a few more paragraphs of detail? Alternatively, we could set up a quick zoom call to discuss.
Also, I have no debt and have about $200k saved and save about $70k/year after taxes and expenses. Please help me get financially free.
First and foremost, the article is written from a money management standpoint not an investing standpoint. That is a key difference to understand.
Second, we always look at managing money from a risk vs return perspective.
Therefore, what that specific paragraph is comparing is two like investments from a risk and return perspective. For example, if you look at VIG (a dividend appreciation ETF) and VUG (a growth ETF). They both go into large cap stocks but VIG’s dividend is almost 3 times more than VUG.
When you compare returns vs risk between the two options over the past 18 years, the overall returns from VUG are only 9% higher than VIG but have 3 times more risk as measured by standard deviation and that is in an era defined by high growth in the stock market. For that much more risk I’d want a lot more return.
As for 401k vs standard brokerage accounts, there is no difference in behavior. The difference is in taxes. Since brokerage accounts are taxed, you would want to hold non-dividend/non-interest paying investments such as the growth fund mentioned above in those types of accounts. The dividend paying and interest paying investments should be held in 401k or other tax deferred vehicles so there is more to compound.