As a relatively new investor and Fool, I've been teaching my teenage son about some of the lessons learned on TMF Boards. Reading Rich McCaffrey's essay on "Focusing on the Best" yesterday, I note his comment "Overall, however, I expect to beat the market by a few percentage points, and for those gains to compound handsomely without the high costs of churn."I had told my son that RM investing doesn't capture the value of compounding interest or value in the same way a high-yield savings account would. But Rich's statement must imply it can, although I don't understand how.Can anyone explain: how does RM investing encourage the advantages of compound interest gains that we older folks used to hear about as the path to wealth?
Hi neuronnorth,Can anyone explain: how does RM investing encourage the advantages of compound interest gains that we older folks used to hear about as the path to wealth?I'll give it a try.The article talked about compounding, not compound interest, but the effect is the same. It is about allowing the profits from one period of investment to be rolled over into another investment. When people think about compound interest, they think of a bank account paying, say, 5% per annum. So, the end of year totals on a $1,000 investment are:Year 1: 1.05*1,000.00=1,050.00Year 2: 1.05*1,050.00=1,102.50Year 3: 1.05*1,102.50=1,157.63etc.However, for the average investor, you are unlikely to commit your money to a bank account that has a fixed interest rate over the long term. So, the fact is that the ideal compounding will not occur. To work out your returns, you calcualte it as the rate changes. For example, if year 1 paid 5%, year 2 paid 4.75% and year 3 paid 5.25%, your returns would now be:Year 1: 1.05.00*1,000.00=1,050.00Year 2: 1.04.75*1,050.00=1,099.88Year 3: 1.05.25*1,102.50=1,157.62If you had the money in a bank account at 5%, but withdrew the interest each year, you would see:Year 1: 1.05*1,000.00=1,050. Take out 50Year 2: 1.05*1,050.00=1,050. Take out 50Year 3: 1.05*1,102.50=1,050. Take out 50The problem with the third scenario is that your capital base is not increasing, so the real value of your capital is falling due to inflation. The only way to keep up with inflation is to take out of your investments a percentage amount that is less than the difference between your profits and the rate of inflation (e.g. if the bank pays 5% and inflation is at 4%, if you take out more than 1%, your capital is decreasing in real terms). If you do not need the income from investments (e.g. your income from work covers your bills), you should not take out any of the profit, to build up the capital before you may need to draw upon it in the future.When you are investing in stocks, you do not know what return you will get. However, when you make a sale, you will have made a given return on a given period of time. If you were to follow an annual reinvestment plan, it would be a simple matter of multiplying the percentage profits each year to calculate the compounding, otherwise it requires that you factor in the period of time.The way that you compound, quite simply, is by reinvesting all of the money that is generated by your investment, just as with a bank account. If you remove the profits each time, you are generating an income rather than compounding the investment.If we beat the market by a small percentage amount a year on average, if we keep on reinvesting those extra profits over many years, the result will be a much greater return than the interest rate alone indicates, as you and your son will have discovered from looking at simple compounding of interest.I hope that this has been of some help.Lost
A good lesson for any investor. Thanks for the analysis and reminder that TMF way is the right way to compounding and maximizing one's gains from stock investments.
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