Compounded Interest

Compound Interest Calculator

Compound interest is the interest you earn on your original investment, as well as the interest that accumulates on that interest over time. This is also known as "interest on interest." Compound interest can help your money grow faster over time, especially when you invest for long periods.

Example

Let's say you invest $1,000 in an account that earns 5% interest per year, compounded annually (no future additions). Here's how your investment would grow over five years:

• Year 1: You earn $50 in interest ($1,000 x 0.05), so your total balance is $1,050.

• Year 2: You earn $52.50 in interest ($1,050 x 0.05), so your total balance is $1,102.50.

• Year 3: You earn $55.13 in interest ($1,102.50 x 0.05), so your total balance is $1,157.63.

• Year 4: You earn $57.88 in interest ($1,157.63 x 0.05), so your total balance is $1,215.51.

• Year 5: You earn $60.78 in interest ($1,215.51 x 0.05), so your total balance is $1,276.29.

As you can see, your investment grows each year, not just by the same amount of interest, but by a larger and larger amount. This is because the interest is being compounded on your original investment plus the interest you've already earned.

Key Points

• The more money you contribute each month, the greater the potential growth.

• The more frequently your interest is compounded, the faster your money will grow. For example, if your interest is compounded quarterly instead of annually, you'll earn more interest over time.

• The higher your interest rate, the faster your money will grow.

• The longer you leave your money invested, the more time compound interest has to work its magic.

I personally use a compound interest calculator. This can help you to figure out your retirement, how to create additional wealth for a short period of time, or even how to retire young (FIRE - Financial Independence, Retire Early).

Typical rate of growth (interest) has been about 7-10% over the past 10 -15 years in the market. For the calculator I use 9% and use a variance of 2% for slower years.

• Remember, even though the market may regress or often lose money (-20%, -10%) it will always be followed by big periods of gains when there is a correction (turnaround)

• Downturns in the market allow you to buy more shares allowing you to pick up at cheaper price which helps to fuel growth when the market rebounds

Dollar Cost Averaging

Power of Dollar Cost Averaging

• Investing into your ROTH, investment fund, index fund, or buying shares every month regardless of price movement

• Long term strategy for investing employed by 401k/403b, IRA's, and other personal investing strategies

  • • Investing with investment funds is typically safe due the funds adjusting for market conditions

    • Works for long term approaches in good companies who will be around

    • If short term holding for personal investment (SEPA - Specific Entry Point Analysis), remember: "We do not catch falling knives" (You get cut)

• As the price rises and falls, you continue to buy shares to increase your holding

• Essentially, when the market is doing poorly you are purchasing more shares then when the market is doing well

• **This is a great strategy for those who may be tight on how much they can contribute monthly or with your ROTH that has a cap on the total annual investment.

**Side note: While dollar cost averaging can be a great strategy, do not confuse this with winning the lottery or large sums of monies at a casino. You should 100% of the time take Lump Sum over Annuity Payments (See Lottery Winning) as the potential of your Lump Sum will outweigh your annuity payments in the long run if managed appropriately.

Dollar Cost Averaging Example

Scenario 1

• Month five there is a spike in price and the share price is now $60

• Strategy A would now be worth $2,400 ($400 gain; 40 shares x $60 = $2,400)

• Strategy B would now be worth $2,820 ($820 gain; 47 shares x $60 = $2,820)

Scenario 2

• Month five there is a spike in price and the share price is now $50

• Strategy A would now be worth $2,000 ($0 gain; 40 shares x $50 = $2,000)

• Strategy B would now be worth $2,350 ($350 gain; 47 shares x $50 = $2,350)

Scenario 3

• Month five there is a spike in price and the share price is now $42

• Strategy A would now be worth $1,680 ($320 loss; 40 shares x $42 = $1,680)

• Strategy B would now be worth $1,680 ($25.85 loss; 47 shares x $42.55 = $1,999.85)

 What Did We Learn?

While we may lose money in the short term, we are investing for the future.

• • In the meantime, if this was a dividend producing stock you could be collecting dividends for each share

  • Collecting dividends can be used to recoup your initial investment over time

  • The dividends could also be reallocated to purchase more shares (essentially free shares)

  • There are other strategies that can be used to leverage your position to make money (see Wheel Strategy)

Opportunity for Exponential Growth

• • Purchasing cheaper shares allows us to reduce the average price of shares

  • The same amount of money can purchase more shares when prices go down

  • Enable us to benefit from buying low, amassing more shares, and selling high

Timing the bottom (Things to Remember)

• • We do not catch falling knives

  • Stocks can go to zero, there is no way to truly tell it is the bottom until its too late (hindsight)

  • Mark Minervini, two time US investing champion, 50/80 Rule on stocks that reach new All-Time Highs (ATH) 

    • 80% chance to drop by 50%

    • 50% chance that it will drop by 80%

Think about it 2: Compound Interest

• Would you rather have purchased all $6,000 worth of shares in the first month or dollar cost averaged over the six months?

• Provide calculations to back up your claim