The Truth About Compound Interest

Albert Einstein called it the 8th wonder of the world and its one of the secrets of the wealthy.  It’s called “compound interest” and it is the prevailing conventional wisdom as to why people “invest for the long term.”  Compound interest is defined as interest that is not only calculated on your initial principal but also on the interest that has accumulated over previous periods.  In other words, interest earned on top of interest.

Compound interest is the mechanism that takes a small amount of money and turns it into a large amount of money (over time).  It is typically displayed as a mountain chart that depicts how money grows to larger and larger sums as a result of interest compounding.  Pictorially think of a chart of how money grows over time in the stock market as that is a good representation.

A infamous chart being the “if you had invested $1 in 1926 it would be worth X today.”  That’s a very good marketing tool as it shows that a person would have made money over time however “compounding” itself requires a closer look…

For a compounding example I will use a penny doubling every day for 30 days.  It would look something like this:

.01 (day 1)
.02
.04

.08
.16
.32
.64
1.28
2.56
5.12
10.24
20.48
40.96
81.96
163.84 (day 15)

327.68

655.36

1,310.72

2,621.44

5,242.88

10,485.76

20,971.52

41,943.04

83,886.08

167,772.16  (day 25)

335,544.32

671,088.64

1,342,177.28

2,684,354.56

5,368,709.12

The three phases of compounding are called the accumulation, growth and takeoff phase*.  Looking at numbers above you will notice that a larger portion of the growth takes place towards the end, in the latter years (the takeoff phase).  These are the years that are responsible for the majority of the growth.

So what conclusions can we draw from these numbers*:

1. Compounding does not work in a straight line.

2. Most of the growth happens in the later stages.

3. No withdrawals can be made from the account.

4. If a year is missed then money is lost in the latter year’s growth.

5. If a person tries to start saving money late in life they will experience only the accumulation (possibly growth) phase of compounding.  (This is why the “catch up” provision on retirement accounts for individuals aged 50 and above does not make sense – they have no time for their money to compound).

So what is the other side of compounding?  Well it’s the unknown factors that are rarely mentioned.  The fees associated with growing money.  The indirect effects inflation will take on the account.  The lost opportunity costs of the taxes that may have been paid (or deferred) over the account’s lifetime or when money is withdrawn out of the account.

Remember if you are deferring the taxes (i.e. employer retirement account) then guess what else is compounding….the taxes.  As the account grows in value so will the tax liability.  It is a totally different story if that penny had an annual expense ratio of 3%, was taxed at 33% and the rate of inflation is 4.5%.  These are the additional components that must be taken into account when looking at how the account will compound over time.

This is why you should take advantage of accounts that will allow you to access money that is not only tax free but one that will perform multiple duties other than simply compounding.  As I stated in a previous article “it’s not what you make it’s what you keep.”  Things that can erode the growth of your account must be taken into consideration when looking at whether compound interest will work to your advantage.

* Bob Castilone

Are Banks A Legal Ponzi Scheme?

Have you  ever wondered why banks exist?  With the current debate over healthcare and bank bailouts taking place in Washington DC it just seemed like a logical question to ask.  Let me first start off by saying that I have never really understood the concept of banks (from a business standpoint) and recent events have further fueled my skepticism.  That being said I have always been curious about one thing when to comes to banks…how do they make their money?

When I walk into a bank there is no product or service they are simply looking for a way to loan me money.  You really are either depositing money or withdrawing money and the bank charges you for the privilege of doing so.  Sure having a checkbook is nice but money orders and the internet have made checkbooks obsolete.  So I began to think…this is either the greatest business model ever created or the biggest legalized ponzi scheme enacted upon people in history (outside of the stock market).

With the recent headlines involving Bernie Madoff I thought it would make sense to start off with defining what a ponzi scheme is.  A quick search on Google bought up the following definition – a ponzi scheme is “a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned.”  Wow…that definition blew me away!  Now substitute the words “ponzi scheme” for “bank.”  A bank is a “investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned.”

It gets even worse….

There is a little main stream knowledge about the practice of these institutions called “fractional reserve banking.”  It sounds complicated but it simply means that banks are legally allowed to lend out more money than they have on hand.  This was a major reason for the meltdown in the economy that has taken place over the past year and that is still continuing with the bank failures that are happening on a weekly basis (104 and counting in 2009 alone).  So hypothetically every time you deposit one dollar into a bank they have the legal right to lend out $10.  This is also known as “leverage.”

So this seems to be how a bank makes money.  We, as depositors, deposit our money into a bank because it is safe and secure protected by FDIC insurance (as noted on the drive through window) and they turn around and lend our money back to us at a higher rate.  Think about it…what is the typical rate on a savings account right now? Less than 1% and what is the rate on your credit card, car loan, student loan, personal loan, home equity loan, and/or mortgage?  Let’s tack on fees for missing a payment, overdrawing your account, not keeping enough money in your account, not using using your credit card, etc, etc…the picture starts to become clearer.

One of the greatest legal ponzi schemes ever created…

A bank makes it money off of the money you deposit into it and they make their money off of interest payments and fees.  Now you see why it is so important for them to find ways to “catch” people with these crazy rules noted in the fine print of the applications and ever changing agreements we sign.  It behooves them to contractually be able to raise rates for any reason or without cause.

It is actually taking Congressional intervention in order to stop banks from charging “excessive” fees and the bank are fighting the legislation tooth and nail!  It’s a great business practice to allow your account to go over the limit or to sell you that variable rate mortgage.  They build in the profit margins on the front end and rake in the dough on the back end and no one is any wiser.  It is literally a multibillion dollar business enterprise built solely off of other people’s money (like the stock market).

It gets even better….

Now fundamentally just by the mere fact that a bank can lend out more than we deposit tells us something that is just common sense…if everyone went to the bank at the same time to withdrawal money it would not be there.  This is why people fear a “run on the banks” because in the back of everyone’s mind they are afraid that one day they can go to a bank to withdraw money and it won’t be there.  Sounds crazy but it can happen…think of September 11, 2001.  A bank DOES NOT have to give you your money back and they can place limits on how much you can withdrawal!

It sounds absurd that a bank wouldn’t have your money but that again goes back to “regulation” (the word absolutely hated by the banking industry) and the fact that they do not have to have money on hand to cover the loans they provide their customers.  Not to mention the amount of leveraging that takes place.  Don’t believe me ask your banker this question:  “is there ever a possibility that I could come to the bank and be denied access to my money?”  If they say “no” you already know they are lying because if that were the case there would not be a need for FDIC insurance and there would not be limits on the amounts of money that FDIC covers.

In closing…

The average person spends over 30% of their after tax income on interest payments alone.  Case in point, look at the amortization schedule of any type of loan you get.  Notice that nearly all the interest is always front loaded so that the bank gets their money first and then the principal gets repaid.  A never ending cycle as people continuously refinance houses and get new cars over their lifetime.

For fun, calculate and total all your current loan payments and see how much of your income is going towards the interest…that’s banking…the great American ponzi scheme in action!!!

The Cause of Bubbles: Financial Engineering vs. Investing

Here is a interesting blog post by Mark Cuban (the owner of the Dallas Mavericks basketball team).  He makes a very interesting point as to why we will continue to have a “boom-bust” economy….His blog is at www.blogmaverick.com.

Oct 10th 2009

The only way to address executive compensation and the inevitable boom and bust cycles that will happen in perpetuity in this country is to finally recognize the difference between financial engineering and investing.  For some reason no one in any of our regulatory agencies seems to want to admit or deal with the differences.  Too much pressure from Wall Street?

In any event, the following is  a post from a year ago. I thought it was worth republishing.

Let me get this straight.  In 2008, funds trying to squeeze out another basis point or two thought they were being conservative buying insurance on heavily leveraged portfolios of subprime loans and other debt. Once those loans started to default, it created a cascading deleveraging event which lead to major financial institutions failing and the “smartest” minds on Wall Street being forced to dump everything to raise cash, which in turn lead to a crisis of confidence and deleveraging that created the worst week in the history of the stock markets. Did I get this right?

In 1987, funds, trying to squeeze out another basis point or two thought they were being conservative buying insurance on leveraged stock portfolios. Once the stock prices on those portfolios started to drop, their insurance programs pushed them to dump everything AND sell stock index futures to raise cash, which in turn lead to a crisis of confidence and deleveraging that created the worst single day melt down in the history of the stock markets.  Did I get this right ?

Think it won’t happen again? Of course it will.  Whatever money the Fed makes available to entrepreneurs and businesspeople will be used as intended, to create and grow businesses.

Unfortunately, it will also be used by financial engineers to try to find a way to make HUGE profits from highly leveraged, risk laden financial packaging. Why wouldn’t they?

If you can borrow cheap money, invest in some asset that can be marked to an increasing market, borrow against the gain and buy something else and do it as many times as possible, wouldn’t you? It’s exactly how homeowners In a bull market drove up real estate prices with a few making huge money.

If you could do the same thing, but instead of with houses, with stocks or asset backed securities, and instead of with thousands, do it with billions so you could profits in the 10s of millions or more, wouldn’t you?

Hell yes you would. You certainly aren’t going to tell yourself that you could be creating the next big bubble that could rival 1929, or for future generations, would rival 2008, so don’t do it. You would go for the money.

Which is the genesis of our problem in the US.  It’s not wrong to run with bull markets and leverage to the hilt. That can be a very good thing. But we have to make the upside based on investments, rather than financial engineering. Which is exactly why we have to change our tax code. We want to encourage investment, not financial engineering.

The financial markets were originally defined as markets that created capital for businesses to start and grow.

Today, that is rarely the case. Sure companies do come to the markets for cash for growth and that should be encouraged.  But those examples are a tiny percentage of the market.  When a stock turns over its float multiple times in a day, those are not investors buying and selling the stock. Those are traders or financial engineers.

The ONLY WAY WE ARE GOING TO END THIS BOOM AND BUST CYCLE IS IF WE DIFFERENTIATE BETWEEN INVESTORS AND EVERYONE ELSE.

Investors should be rewarded for actually owning companies and gaining returns on their investments. Financial engineers should have to pay a premium for the risk they introduce to the entire financial system. It was not investors that brought on the last 2 crashes. It was the financial engineers.

The beautiful thing about this country is that we like to work hard, and we like to take chances. Unfortunately, over the last 15 years, the incentives have been to take chances as a financial engineer rather than as an entrepreneur. We give far more money to people who play games with financial instruments than we give to people who come up with ideas for the next big thing.  That needs to change if we want to remain a leader in this world.

Here is what I would do to change things

I would change to zero the taxes on any gains from the sale of stock or bonds purchased during an IPO and held for 5 or more years. All dividends/interest paid by that stock/bond would be tax free. If you sell it prior to the 5 years, you are taxed at your personal regular income tax rate.

In addition, I would not allow the stock to be borrowed against in any way. If it was, it would be considered an effective sale. Which means you couldn’t borrow on it tax free until you have held it 5 years.  Bottom line, if you hold the stock/bond, like a real investor would, you are rewarded for it.

For purchases  post IPO, in the open market,  the same rules apply, except I would tax a personal income rates the dividends/interest  for the first 5 years of ownership.

For all other transactions, whether they are options, derivatives, stocks, bonds, whatever, all gains and losses would be taxed at personal income rates.

If you are a great financial engineer and make tons of money at what you are doing, more power to you.  If you are good at what you do, you pay more to Uncle Sam, but you still make a boatload of money.

I would keep taxes on private transactions, just where they are. Private transactions are less liquid and harder to value, which in turn makes them harder to borrow against. Which reduces leverage in the system and encourages investment. It’s hard to financial engineers a private company. I would tax gains and losses in private companies at capital gains levels, but I would extend to  3 years the marker to not be considered a short term investment. I would keep the active vs. passive rules.

Next there is the issue of leveraging. No one ever complains when cheap cost of funds creates leverage and drives a market up.  And no one ever will. So we have to set strict leverage limits. We set margin/leverage limits on day traders as the tech bubble burst. The only difference between the day traders of the tech bubble and the Investment Banks and AIGs of the world that cratered in this bubble is that the big guys started with more chips at the table. And they picked their own credit lines and there was no pit boss to watch over them. I would limit to 2x the leverage available on any asset that is insured by the government or is offered by any organization that is eligible for government insurance or tax incentives of any kind.

Of course, I would still levy a fee of anywhere from 1c to 10c on every transaction of stocks or bonds which would go into a general fund, that I will call the “Oh Shit We Missed It Fund”. It will be there to fund the inevitable situation where someone figures out how to work around whatever regulations and tax code that is created.

As an entrepreneur, I can tell you that this would not change how I ever started or invested in any business. As someone who trades stocks, It would impact my investment decisions. I would only trade out of necessity. I would be willing to take lower yields on my investments, making it cheaper for companies to raise funding.

I also recognize that it would mean that the chances of the Dow ever hitting 14k in 2008 dollars is about as likely as my catching my elbow on the rim playing basketball. I don’t think that’s a bad thing.