Adams Financial Concepts,  Financial Planning,  Return on Investment,  The Investment Industry

The Amazing Power of Compound Interest

Albert Einstein called it the Eighth Wonder of the World. He elaborated saying: He who understands it, earns it; he who doesn’t, pays it.” Einstein was referring to compound interest. A little bit makes a big difference. You wouldn’t think the difference between 5% and 10% over 25 years would be that much, but if you invest $100,000 at 5% for 25 years you will have a nice, tidy sum of $ 338,635. Doesn’t that sound pretty nice? Most financial plans are geared for that type of return.

But what would it be if that $100,000 grew at 10% over those 25 years? Before you read on, take a guess at what you think $100,000 would be worth after 25 years at 10%. Do you have a number in mind? Then read on.

But before I give you the answer, let me ask another question: I started my career with a national brokerage house and spent the first 18 years of my financial services time working for those big brokerage firms. They used to tell us, “Sell the relationship, not the performance.” What did they mean? Josh Brown, whom you may have seen on CNBC, tells us the following in his book Backstage Wallstreet:

“Most of the brokers [financial advisors] I know and have met over the years are phenomenal, world-class sales people…But a great many of these security selling savants don’t attain the knowledge necessary to actually accomplish anything for their clients… Selling one’s expertise is much easier than actually developing an expertise, especially as it pertains to investing.”[1]

They will take all your information and plug it into a computer and give you a computer-generated financial plan that can run 400 pages or more with glorious looking pie charts and line diagrams and tables all in a rainbow of colors that supposedly lays out your entire financial future. They will run Monte Carlo Simulation and show you the probabilities of not ever running out of money. The computer does all of that and they will meet with you once a quarter or once a year and update all that information.

Of course, what they don’t tell you is that plan is based on a static world where nothing really changes. They don’t tell you stock markets are not symmetrical so the Monte Carlo Simulation doesn’t really tell you that you will not run out of money. They also don’t tell you there is nothing in the plan to prepare for “black swans” like Great Recessions and pandemics and other dramatic and unanticipated events.

Maybe I am skeptical of the process because I am a mathematician and I realize the fallacy of the statistical methods financial plans use. But I also began my career before financial planning was the sales tool of financial advisors. When I began in the business, if you did not make money for clients, they fired you. It was about performance not the relationship.

We did not have quarterly or annual meetings with clients. In fact, I have clients with whom I have worked for over three decades and never met. When we began to charge fees instead of transaction commissions, meetings suddenly became important. It was important for financial advisors to justify their fees even though their accounts were losing money.

If brokers could not sell on the quality of their returns, then marketing teams had to find another hook, and so the idea became to “sell the relationship, not the performance”. There is a cartoon that dates to 1987 that I wish I had cut out of the paper. It showed a couple meeting with their financial advisor and the advisor said, “You lost $50,000 and I made $50,000 in fees, so I guess we could call that even.” That cartoon really begged the question most clients should be asking: “What am I getting for what I pay?”

Financial advisors want you to like them. They want you to like them so much you do not care that your account is up only 5% when the market is up 10%. That’s just a small difference, right?

That brings us back to the question I posed at the beginning of this newsletter: how much would you return if $100,000 was invested at 10% for 25 years?

$100,000 invested at 10% for 25 years would grow to $862,308!

By this logic, then, how much would that $100,000 have grown if it were invested at 15%, by a very skilled investor? $3,291,895! That is the power of compound interest.

That takes me back to Albert Einstein’s quote, which I reinterpret as: If you are not taking advantage of compounding and making it work for you, then it will be working against you. You may be paying 1% in fees, but the real cost is not the 1% fee it is the difference between what you could be making and what you really are making.

Which brings me to one more point. We can begin to say goodbye to 2020 and hello to 2021. Stocks are valued on what companies earn; beginning in June, analysts begin to shift from earnings in 2020 to forecasting earnings in 2021. The stock market will be driven more and more on expectations for 2021 now we are at the mid-year point.

It is a time to make compounding work for- and not against you. You should see how your account has done over the first five months of this year. The S&P 500 is now break-even with the end of 2019. I know my clients are seeing new highs in their accounts and have been seeing that for several weeks.

If you are dragging bottom, it is a time for thought: financial advisors are taught by their firms to “teach” you not to look at your account performance. They want you to just like them. There will be more black swan events and there is no guarantee the next black swan won’t last for years and years rather than a few months. For every $100,000 you have, would you rather end with $338,835 or $862,308, or maybe $3,291,895? You don’t have to be Einstein to understand this difference.

I do not believe it’s true that greater returns mean greater risk. That is another topic. If you’re curious, however, I’d be happy to walk you through the math one-on-one. Simply respond to this letter. I believe higher returns can come with lesser risk. It is simple math.


[1] Brown, Joshua M., Backstage Wall Street: An Insider’s Guide to Knowing Who to Trust, Who to Run From, and How to Maximize Your Investments (McGraw-Hill Education: 2012).

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