NEW YORK (TheStreet) – There was a time when compound interest was all investors needed to put their money to work.
These days, compound interest doesn't even give your money a light cardio workout. For those who are tired of watching their hard-earned money stagnate in savings and checking accounts and other low-yield vehicles, compound interest can be helpful, but it doesn't provide all of the answers.
“Compound interest is nothing more than having your interest reinvested into whatever your investment vehicle is,” says Barry Zischang, certified financial planner and vice president of wealth strategies consultant/estate and high net worth at RBC Wealth Management's Micera Investment Group. “Essentially, you're earning interest on your interest over a period of time. Instead of taking your money out and investing it in something else or spending it somewhere else, you're plowing it back in and letting it grow on a compounding basis over time.”
To make compound interest work, you need a little bit of upfront investment and some time. However, with interest rates low, reinvesting dividends in stocks that provide a dividend can provide growth far greater than compound interest.
“Compounding is one of the greatest things in finance in terms of investing in general,” says Mike Sorrentino, a CFA and chief strategist at Global Financial Private Capital. “It's a snowball effect in which the first few years of not-so-impressive returns — 4%, 5% or 6% — may not excite an investor, but as you get further on down the line, it turns into real gains.”
How much time? Sorrentino and Zischang suggest that investors use the Rule of 72 to figure out just how quickly compounding can work. If investors take their rate and divide it into the number 72, that should give them a rough estimate of just how many years it should take to double their money with any one investment.
If your investment has a 6% average annual growth rate, the Rule of 72 indicates that it should take about a dozen years for that investment to double.
“When you're talking about compounding, you have to have a long-term time horizon,” Sorrentino says. “You don't really see the benefits of compound interest until between 9 and 15 years.”
While people closer to retirement age may not have the time to benefit from compounding, it can be a huge help for younger investors looking for the quickest ways to build a nest egg. Sorrentino and Zischang addressed a couple of options for investors and we've listed them from most- to least-effective:
Yes, stocks are volatile and come with some risk, but remember that compounding is a long-term proposition. Investing well in equities has some distinct advantages.
"A lot of people consider equities to be high-risk, and they can be, but in the long run they've been the best-performing asset class out there," Sorrentino says. "The long-term average annual return for equities is right around 10%. According to the rule of 72, you'll double your money in 7.2 years on average with equities or an index fund of some sort."
Also, down periods aren't necessarily a bad thing. Zischang notes that one of the benefits of the compounding effect is that you are always reinvesting at the price at the time of reinvestment. If you're in a down year, you're buying shares at that low price. Sticking with equities gives shares time to recover from an interest rate change, bad jobs report or some other piece of news that makes an investment react in the short term. By continuing to reinvest, you're taking advantage of the time when prices are down to reinvest at a bit of a discount.
Even if you dip a toe into equities by investing in a work 401(k) or an Individual Retirement Aaccount, there's a strong chance of coming out ahead if you stick with it for the long haul. Since 1980, the value of shares on the S&P 500 has risen 1,800%. That includes multiple recessions, the turn-of-the-century dot-com bust, the recent financial crisis, Bernie Madoff, Enron and everything else.
"We may not see amazing growth as we have in the last 30 to 40 years and the new normal may be slower growth going forward," Sorrentino says. "But even if 10% equity returns turn into 7% equity returns, compound interest will still get you paid."
Welcome to ETFs. Representative of many different types of assets, from bonds and treasury bonds to stocks, ETFs exist in different forms for different asset classes, risk profiles and returns. Many pay a dividend that investors can pile right back into the ETF, but they also tend to require a bit of maintenance.
"The ETFs out there these days are very liquid and lower-cost than your typical mutual funds," Sorrentino says. "Whether it's a bond ETF or income-generating ETF, any income it produces you're going to have to reinvest into that fund in order to reap the benefits of compounding. If you do go the ETF route, you have to reinvest those dividends or you'll just have that static principal."
Because of the makeup of ETFs, however, they can be a bit volatile. There are going to be down years when the ETF loses money, but that volatility shouldn't be reduced to outright risk. Investors can play it safe by investing in global ETFs and diversifying their holdings by type and region, but Sorrentino says the most important thing investors need to do with their ETFs is be patient.
"You're going to see a couple of recessions, but the average investor doesn't have the time to go in and manage those accounts," he says. "Equity ETFs are good, but you have to give it some time to grow."
By combining a variety of different assets including stocks and bonds, mutual funds provide a bit of diversity to folks willing to reinvest their dividends and capital gains into the fund. That said, mutual funds are also problematic.
"I'm not a huge fan of mutual funds," Sorrentino says. "I think their fees are a little high, and they're a little screwy when it comes to taxes."
U.S. Savings Bonds
"Typically, you buy those at a certain price and they'll mature at a guaranteed level in the future," Zischang says. "Those, too, give you the benefit of compounding interest with the additional benefit of tax deferral."
That said, it takes a while. Sorrentino points out that folks investing in U.S. savings bonds are locking themselves into 2.5% annual gains for the next 30 years. He sees that gain being overtaken by inflation at some point, but notes that the Fed's interest in raising interest rates will make bonds less of a shelter than they've been in recent years.
"There's this idea that bonds are a safe investment, and that's not the case," Sorrentino says. "Bonds have gone up for the last 30-something years because interest rates have gone down the whole time. Try managing a bond portfolio in a rising-interest-rate environment."
Certificates of Deposit
The classic compound interest product for many years was the good old CD, emphasis on "old."
"The FDIC-insured certificate of deposit would provide you with a standard interest rate over a specific period of time and your interest would compound over that period of time,” Zischang says. “Of course, when interest rates were higher, it was great. It was a great way for investors, whether they were novices or not, to enjoy the benefits of compound interest.”
Unfortunately, the rates on a CD haven't been great in a long time. Current CD rates drift between 0.2% and 1.2%, which isn't great when you consider that the rate of inflation in 2014 was 1.6%. By locking in those low rates, Sorrentino says that investors are locking in a loss of buying power. While the Federal Reserve has been making noise about raising interest rates, Sorrentino notes that it took interest rates nearly two decades to recover from the Great Depression and more than three decades to reach their previous peak.
“A potential investor who's extremely risk-averse asked me when the Fed raising interest rates would translate to getting 5% out of a bank CD,” he says. “I have this conversation once a week: The days of 5% bank CDs are over, and they're not coming back in our lifetimes.”
This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.