Compound interest investments can potentially generate returns over a long period of time, but there are a few things to consider, such as time, reinvestment, and the importance of risk management.
Key points to remember
- When it comes to capitalization, it is important to consider the effects of time, reinvestment and risk
- Over time, different assets grow at different rates, so consider periodically reviewing and rebalancing your portfolio.
Portfolio management is the ongoing maintenance of your long-term investment portfolio. This may include reviewing your asset allocations, adding new money, reinvesting interest and dividends, managing risk by rebalancing, and maintaining a long-term perspective.
First, a long-term investor can potentially harness the power of compounding returns (commonly referred to as compound interest in the case of bonds, certificates of deposit (CDs), and other fixed income investments). Compound interest is basically interest earned on top of interest. When it comes to composition, there are three things to consider:
- The sooner money is put to work, the sooner it can begin to grow.
- Reinvestment can contribute to compound growth.
- Excessive risk can contribute to large losses, which can erode the long-term effects of compounding.
Compound interest has been called the eighth wonder of the world. And when you look at a graph like Figure 1, the effects can be impressive. But really, it’s just simple math. But as we’ll see in the next section, it may be a bit too simple, meaning it doesn’t take into account setbacks, like corrections, bear markets, and recessions, that can occur in the pipeline. of road.
FIGURE 1: THE POWER OF COMPOSING. A $24,000 investment at a stable compound interest rate gives a significantly higher total when it started 26 years earlier. For illustrative purposes only. Past performance does not guarantee future results.
The Basics of Compositing
Suppose you have $1,000 earning 5% per year. It’s $50 a year, right? Yes, but then it starts to get worse. After that first year at 5% interest, you now have $1,050. Add the same 5% interest and you get $52.50 in the second year for a total of $1,102.50. In the third year, your total increases to $1,157.63 ($1,102.50 x 1.05). Yes, the additional earnings beyond the initial $50 interest are minimal at first, but they grow in size over time.
That’s why it’s important to reinvest any compound returns. If, instead of reinvesting that $50, you withdrew it and spent it on a nice dinner out, you would only earn $50 more in year two instead of the compounded $52.50. There’s nothing wrong with the occasional splurge, but when it comes to investing for the future, you can’t have your capitalization and eat it too.
Risk management: an act of rebalancing
Now that we’ve looked at the importance of time and reinvestment, let’s turn our attention to risk. Over time, assets such as stocks or bonds grow at different rates. Bonds are designed to provide a fixed rate of return and are generally considered less risky. Over longer periods, the stock market has always delivered higher returns, but as the standard disclaimer goes, past performance is no guarantee of future results. The stock market can be volatile, and volatility can expose you to outsized losses on certain assets.
Say you’ve assessed your goals and risk tolerance and agreed on a 50/50 combination of stocks and bonds. Figure 2 shows how a hypothetical portfolio could become “unbalanced” over time if left as is. That’s why it’s important to consider periodic rebalancing of your portfolio to maintain your target asset allocation.
FIGURE 2: THE IMPORTANCE OF REBALANCING. Over a 20-year period, a hypothetical 50/50 split gradually becomes 69% stocks and 31% bonds. Data sources: Small stocks are represented by the Ibbotson Small Company Stock Index. The big stocks are represented by the Ibbotson Large Company Stock Index. Mid-term government bonds are represented by the five-year US government bond. An investment cannot be made directly in an index. Data assumes reinvestment of earnings and does not take into account taxes or transaction costs. Image source: Morningstar. For illustrative purposes only. Past performance does not guarantee future results.
Note how the allocation distribution changes during each five-year period. The 50/50 mix becomes 60/40, then 63/37. This imbalance creates higher risk in the portfolio, resulting in greater fluctuations in its value by 2005. Subsequent market fluctuations lead to a decrease in equity allocation to 60% by 2010 and an increase to 69% by 2015.
Note two key points here. The actual portfolio allocation at the end of the period is radically different from the initial target allocation of 50/50. And as the stock allocation increased, so did the overall portfolio risk.
How can an investor help manage this risk and maintain a long-term perspective? Consider doing a portfolio review every quarter to determine if you need to rebalance your assets. Rebalancing simply means selling part of an asset that has become overweight. These funds are then added to an underweight asset, restoring your target allocations.
You can also manage risk and restore your target asset allocations by adding fresh money to a portfolio. For example, if you started with an allocation of 50% stocks and 50% bonds, and grew to 60% stocks and 40% bonds, you can direct the new money to the obligations. Over time, the bond allocation should grow and realign with your target 50/50 allocation.
Ultimately, portfolio management comes down to risk management and patience. Remember that when it comes to your investments, compound interest and compound returns can be important allies. Growing your money as soon as possible gives it more time to grow and recover from any downturns along the way. For more on the power of compounding, watch the video below.