You work hard for your money. You're exercising the self discipline to invest some of your money to make more money. Whether you're sending a child to school, buying a house, preparing for retirement, or building wealth, you'd rather double your money than lose it. What you invest in is important. So is how you invest.
One of the best reasons to invest in the stock of a good company (rather than investing in precious metals such as gold or silver or some opaque ETF) is that good businesses grow. That little coffee and pastry shop in Canada that went public and is now spreading throughout the northeast United States has the potential to grow all across North America. That semiconductor company which has just shipped its billionth chip has the potential to sell ten billion every year for the next decade.
Good businesses grow. That growth, if properly applied, can accelerate future growth. This is the secret magic of investing well.
Calculate Compound Interest with the Rule of 72
As you remember, compound interest is interest that generates more interest. Simple interest is interest that doesn't get reinvested. If you loan your brother in law $500 and he pays you 3% simple interest in a year, you'll get $500 plus $15. That's simple and easy. If you loan him that $515 for another year at 3% interest, you'll get $515 back plus $15.45. If you loan him that $530.45, and so on and so on.
Compound interest earns money not only on the principal but on the interest you've already accumulated. Sure, you know that. Here's the interesting part; you can use that to predict things.
If you keep loaning your brother in law that money plus interest again and again, how long before you've turned that $500 into $1000? There's a simple rule of thumb to figure it out. Take the compounding interest rate—3%, here—and divide 72 by that number. 72 divided by 3 is 24, so it'll take 24 interest periods—years, here—to double your money. If you charge him 6% per year, it'll take 12 years to double your money. If you charge him 3% every month, you will double your money in 24 months.
Remember, you have to keep every penny of interest you earn in the investment to compound at the rate you earn.
Stocks and Your Effective Rate of Return
You can also use the rule of 72 to figure out how well your investments are doing across your entire portfolio (stocks, bonds, precious metals, cash and cash equivalents). Calculating your effective annual return gives you a rough idea of how often you can double your investment. For example, Trendshare's discounted cash flow projections use 15% as a baseline. This gives a 12% annual return after inflation and (long-term capital gains) taxes. At 12% a year, it takes six years to double an investment. If you start investing now with the intent to retire in 30 years, every dollar you invest now will turn in to $32.
There's more fun in these numbers if you bring in some middle-school algebra. If you intend to retire in 30 years with a million dollars and aim for a 12% annual return, your multiplier is 32. Divide the end result of $1,000,000 by 32. You need to invest $31,250 right now, earn 12% annually on average, and never invest another penny to get a million dollars.
You may not have $30k lying around right now and you may be older or younger than our hypothetical 35 year old person. You might want more than a million dollars. The Investor.gov compound interest calculator lets you play with the numbers. You can choose your starting principal, how much you invest monthly, and the interest rate you earn annually. It's good for getting into specific details, but the rule of 72 is easy to remember and a great place to start.
How to Compound Stock Returns
All of this explanation is well and good, but it rests on the idea that you can reinvest your interest to roll it up into the principal. That's easy to do with a bank account or a CD. How do you do that with a stock? Compound interest in the stock market works the same way.
A business has several options to make itself more valuable. It can reinvest its profits into growth (inventing new products, opening new stores or factories, reducing expenses, or buying other companies). It can buy back shares of the stock (increasing the earnings per share by reducing the number of shares outstanding). It can pay off debt (reducing liabilities and improving the balance sheet).
Good businesses—businesses you want to invest in—do this. Warren Buffett's Berkshire-Hathaway is famous for reinvesting profits into the business. Buffett's theory is this: that if he and Charlie Munger can provide a better return on that money by finding good investments for it, shareholders are better off than if they tried to invest that money themselves.
Not all companies share this philosophy. Some companies pay dividends. (Many of these dividend stocks belong to companies which reinvest some of their profits.)
There's nothing intrinsically wrong with paying dividends (in certain circumstances, buying dividend stocks is the right choice), but there are two subtle implications of receiving a dividend. First, you have to pay taxes on the money. Unless you have a fantastic strategy for delaying capital gains taxes on interest income, you'll pay taxes for every dollar of dividend income you get in that year. Second, that money is not necessarily compounding for you unless you reinvest it. The important question is how to invest your money to make money; same question for businesses as for individuals.
Again, the only money that compounds for you is the money you've rolled into the principal. If you get 12% returns from the stock itself and 3% in dividends, you'll only compound your 15% return if you reinvest your dividends. You're probably paying taxes on that 3%, so it's very likely less than 15% when all is said and done.
Dividend Reinvesting versus Buying Other Stocks
There's nothing wrong with a stock that pays dividends. It's a useful and valuable thing, and it can attract buy and hold investors who treat the business like a business. Yet if you've found a great company and you want to hold it for 30 years, you might want to sign up for a dividend reinvesting program to buy more shares of that stock with the money you've received from dividends. That'll help you take advantage of compounding interest.
An alternate approach is to use your quarterly checks to invest in other companies. In this sense, you'll compound your investment by putting your dividends into your total portfolio principal, not just Coca-Cola or McDonald's. This is a great approach if you have a stable of good opportunities.
Doubling Your Money in the Stock Market Takes Time
The rule of 72 can help you find good investments and analyze your rate of return. It's not the secret of how to double your money in a year (there's no iron-clad secret for that, not even penny stock trading; you have to get 6% returns every month to double your money every year). Instead, it's a sober reminder that building true wealth through investing takes time.
Set your expectations appropriately. Turning $31,250 into a million dollars in 30 years is impressive. You need the discipline to find good investments and the patience to watch them grow, but if you have the ability to reinvest your profits back into your investments, compounding interest will produce for you great returns over time.
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