You’ve learned a lot about investing over the years, and you want to pass along what you know to the next generation. Our clients often seek to educate their children on how to be responsible and prudent stewards of wealth. It can be overwhelming trying to determine where to begin, so we recommend you begin with the basics.
Today, we’ll look at the power of compound interest as well market timing.
Compound Interest is Key
Albert Einstein described compound interest as the eighth wonder of the world. In his words, “He who understands it, earns it. He who doesn’t, pays it.”
Numerous books from the Automatic Millionaire to One Up on Wall Street highlight the payoff of compound interest. Emphasize to your children the same message in these books: time is on your side and that over long periods of time, compound interest is key to success.
Compound interest is calculated on the original principal dollar, which also includes the accumulated interest of previous periods. This is true regardless of the investment and can be conservative or aggressive in nature. Remember, this is different than simple interest, which is a one-time calculation on the principal amount. Compound interest builds on itself and allows the earnings to be invested and grow as well. Basically, it’s interest that’s earning interest.
Here’s an example to share. Say you have a one-time investment of $1,200 with a 5% interest rate. After 30 years, you would earn $3,000 with simple interest. However, using annual compound interest would yield over 70% more – $5,186!
If $5,000 can grow to $2.4 million in 40 years, just think, over 60 years it can grow to $16.6 million. That’s the power of compound interest.
Compound interest is vital to accumulating wealth. While we recommend our investors revisit their investment goals and objectives over short-term, we want to stress that it’s imperative to invest for the long-term.
Good Luck Timing the Market
It’s best to tell your children now that it’s nearly impossible to correctly time the market to get the highest returns. Despite knowing this, many investors still try to do it. It doesn’t help that it seems every television market analyst sounds a bell, whistle or air horn to alert viewers of an opportunity.
While some investors claim it’s possible to time the market, overwhelming evidence suggests otherwise.
Historically, the best days in the market are frequently followed by the worst, so trying to time the market can cause investors to miss the “best days.”
Yes, an investor may have missed the worst days, but in turn, the investor also likely missed out on the best days, which means significantly lower returns.
Dalbar, Inc.’s annual Investor Behavior Study illustrates this point. In their most recent study, they concluded the average investor in 2018 ended the year with a loss of -9.42% while the S&P 500 Index only retreated -4.38%.
Other firms analyze scenarios where investors miss the best days of the market over a given time period.
The graphic shows the S&P 500 returns of a $10,000 investment between 1999 and 2018. Over these two decades, the investment would have earned a 5.62% return if it remained fully invested.
However, excluding the 10 best days the investment would have only earned a 2.01% return.
Between 1999 and 2018, six of the market’s 10 best days occurred within two weeks of the 10 worst days. An investor trying to time the market who avoided the 10 worst days would have also missed the 10 best days, meaning they likely received a lower return on their investment.
To time the market, you have to make two correct predictions: when to get out and when to get back in. For investors who wanted to avoid the market downturn in 2008 but missed the subsequent 10-plus year bull market, this is a painful reminder.
Market timing is almost impossible and attempting it frequently can wreak havoc on asset allocation. As fiduciaries, we work with our clients throughout the year to address portfolio changes, ensuring long-term goals are in view.
Most investors understand the importance of investing early and often. However, the question becomes, “When should I invest my money?” The media frequently infers that anyone can time the market, with a little effort. However, there are empirical studies refuting that sentiment. While it can make for stimulating conversation in social settings, it certainly is not prudent.
It can be a bit intimidating to discuss wealth accumulation and preservation with your children. However, we know this is an important topic for our clients. Remember, we can work with you to help educate the next generation to be good financial stewards of family wealth.
With the holiday season upon us, perhaps your children are visiting for a period of time. We find this time of year to be a natural starting point for the discussion. And, we encourage you to make discussions like these an annual endeavor, while most children will be in one place.
We know that, just like the topics discussed today, with small, consistent additions and a long time frame, great wealth and knowledge can be achieved.
 Dalbar, Inc. (2019, March 25). “Average Investor blown away by market turmoil in 2018.” [Press Release]
 J.P. Morgan Asset Management. 2019 Guide to Retirement.