You’ve heard of it quite often, most likely when choosing a 401(k) investment, but compound interest is perhaps the smartest investment strategy one can adopt, no matter what. investment of his choice. The name of the game with compound interest is time, and the more you have, the bigger the payoff. This means that if you are a short-term investor or looking to stay mostly liquid, this strategy is probably not the best fit for you.
What is compound interest?
Compound interest is the interest you earn on interest. In short, you make an initial investment and receive a particular rate of return in the first year, which then multiplies from year to year based on the interest rate received.
Let’s say you make a $100 investment and you receive a rate of return (ROR) of 7% in the first year. The interest has not yet been compounded because you are at the start of the investment.
But then, in the second year, you clean up another 7% ROR on that same investment. This means that your original $100 increases as follows:
Year 1: $100 x 1.07 = $107
Year 2: $107 x 1.07 = $114.49
The $0.49 is compound interest earned from year one through year two, as it is interest earned on top of the initial $7 of interest earned after year one. The $7 earned in the first year is simple interest. Once this initial simple interest is earned, that is when interest begins to accrue interest, which is defined as “compound interest”.
It may not seem like much, but compound interest really takes off in long-term investment accounts.
For the purposes of the example, assume an account with a balance of $20,000 and an average ROR of 7% (10% is roughly the historical average ROR for the S&P 500 since its inception, and 7% can be considered as relatively conservative.)
Year 1: $20,000 x 1.07 = $21,400
Year 2: $21,400 x 1.07 = $22,898
In two years, you’ll have made nearly $3,000 with $98 in compound interest, just by keeping it invested.
Use the rule of 72 to estimate when your money will double
Over a lifetime, you can double, triple or “over the moon” your investment. An easy tool to estimate this is the Rule of 72, which is a calculation that estimates the number of years it takes to double your money at a specific rate of return. The calculation divides 72 by the assumed rate of return to estimate how many years it will take to double your investment.
In our example above, assuming an ROR of 7%, you can calculate that 72/7 = 10.28, so it will take about 10 years to double your investment.
To maximize this strategy, it’s important to keep in mind that consistency – and courage – are key. The ROR is an assumed average over decades, which means that a winning strategy will see several economic troughs and peaks that investors will need to overcome.
Best Compound Interest Investments
To take advantage of the magic of compound interest, here are some of the best investments below:
Certificates of Deposit (CDs)
If you’re a newbie investor and want to start enjoying compound interest right away with as little risk as possible, savings vehicles such as CDs and savings accounts are the way to go. CDs are instruments issued by banks that require a minimum deposit and pay you interest at regular intervals.
The money is locked in until the CD matures, but will generally pay a higher interest rate than a regular savings account. CDs from online institutions and credit unions tend to pay the highest rates. The duration of a CD varies, most often ranging from three months to five years. Once the CD matures, you will have full access to your money without having to pay early withdrawal penalties. So if you need the money sooner, you can select a shorter term CD to give you a bit more interest than if it was just sitting in a checking account.
High Yield Savings Accounts
High-yield savings accounts typically don’t require a minimum balance (or a very low balance) and pay a higher interest rate than a typical savings account.
With rising interest rates and inflation, money that sits in a non-interest bearing account is wasted money. One of the main advantages of high-yield savings accounts is that you earn interest while enjoying the security and FDIC insurance (up to $250,000 per account) of a traditional savings account. . Unlike most traditional savings accounts, you may need to maintain certain minimum balances in order to receive the advertised interest rate. You will therefore need to ensure that you select an account within the limits you are comfortable with.
Although CDs and high-yield savings accounts generally earn more than having your money in a traditional savings account, they will struggle to keep up with inflation. In order to stay ahead of the price spike, an investor should probably consider more aggressive options.
Bonds and bond funds
Bonds are generally considered a good compound investment. These are basically loans that are given to a creditor, whether it is a company or a government entity. This entity or company then agrees to give a specified return in exchange for the investor buying the debt.
Keep in mind that you will need to reinvest the interest paid on a bond in order to compound the interest. Bond funds can also generate compound interest, but must be set up to automatically reinvest the interest.
Bonds will have different levels of risk. Long-term corporate bonds are riskier but offer higher yields, while US Treasury securities are considered one of the safest investments you can make, as they are backed by full confidence and the credit of the US government.
Bonds can be beneficial for an investor who wants to hold their investment for the long term, but can be riskier than CDs and high-yield savings accounts. Indeed, the price of bonds can fluctuate during their lifetime. As prevailing interest rates rise, the price of existing fixed-term bonds may fall. On the other hand, if rates fall, the price of the bond will rise. Regardless of what happens in the meantime, when the bond matures, it will return its face value to investors.
Money market accounts
Money market accounts are interest-bearing accounts similar to savings accounts. Unlike high-yield savings accounts and CDs, which also pay higher interest rates than a traditional savings account, money market accounts often allow check writing and credit card privileges. debit. These provide easy access to your assets while earning slightly higher interest than you would in a regular savings account.
Investments that can make your money grow a little faster
With today’s low interest rates, it’s usually difficult to deal with interest-only investments, but investors can also take advantage of compounding by investing in high-yielding investments and reinvesting earnings.
While long-term stocks alone are a good investment for accumulating growth, dividend-paying stocks are even better. Dividend stocks pack a punch because the underlying asset can continue to increase in value while paying dividends and this investment can earn compound interest if the payments are reinvested.
If you’re looking for dividend income, you might want to look to the group of stocks known as the “Dividend Aristocrats”. This group of S&P 500 companies has increased its dividends per share for at least 25 consecutive years. Some companies on this list include Coca-Cola, Walmart, and IBM. So, for a novice investor looking to potentially beat inflation while accumulating long-term income, dividend stocks and dividend aristocrats are a good way to go.
Keep in mind that these companies also tend to be more stable and less volatile, so they may not offer as much potential for outsized returns as the higher growth stocks.
Real Estate Investment Trusts (REITs)
REITs are a great way to diversify your portfolio by investing in real estate without having to buy the property directly. REITs return at least 90% of their taxable income to their shareholders each year in the form of dividends. As with other dividend-paying stocks, investors must reinvest their payouts in order to reap the benefits of compounding over time.
REIT investors should be aware that these investments are quite different from a savings account or CD. REITs are sensitive to changes in interest rates, which affect the real estate market disproportionately compared to other assets. And unlike those very safe banking products, the price of REITs can go up and down a lot over time.
At the end of the line
Less risky compound interest investments like CDs and savings accounts will be safer options, but are more likely to earn you a lower return. Choices like REITs and dividend-paying stocks can give you a higher return with reinvested dividends, but will require higher risk tolerance to weather the ups and downs of the stock market. The most important thing to remember is that capitalization will not happen effectively without a long-term horizon.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are cautioned that past performance of investment products does not guarantee future price appreciation.