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The Big Problem With Compound Interest

By Edited Nov 13, 2013 0 0

When people talk about compounding and the calculation behind it, quite often, there is a tendency to imply a consistent percentage, or interest, which the sum would compound at. Fundamentally, this is flawed.

The market has never yet given a consistent interest over a substatial period of time.

If you are to take anything from this article on compound interest, it is this: calculate your final saving yield as a rough gauge only.  

A History Of The Stock Market Return

Taking the S&P 500 (the benchmark for stocks and equities), the rate of return is listed down for your reference.

 

Year Rate Of Investment (ROI)
2005 4.91%
2006 15.79%
2007 5.49%
2008 −37.00%
2009 26.46%
2010 15.06%

 

Thus when you are calculating your sum needed for your retirement, you are assuming a certain ideal, a certain artificial condition that is very, very unlikely to materialize (and if it did, it will only be for a short term). While you can control the amount to invest in, the rate of return would most probably differ from year to year.

Is Compounding Interest Useless?

Not at all. While it is almost impossible to calculate precisely when you can retire, the approximation is still a pretty good gauge. (And let’s face it, some of us do not even bother with the basics of planning for retirement.)

You would have to be slightly pessimistic in your calculation and plan for the worst-case-scenario. This is commonsense.  If you assumed an almost foolishly optimistic attitude when it comes to dealing with your finance, chances are, you will mess up when the market does not meet your high expectation. (An example would be to assume a high 20% annual rate of return on your investment. That is a very, very optimistic forecast.)

Long Term Investing

Therefore, for any investment to work out well, you would have to invest in the long term. Over time, any bad year would be evened out along with the perks that you experienced in the long run. As I have mentioned earlier in Compound Interest, it is only in the later years that your investment will actually snowball to a substantial amount, and the longer you invest, the more effect your compound interest will have on your investments.

So take note. There is a limitation to what the theoratical approach to compound interest can do for you when you assumed it to be consistently compounded, and you would be wise to recognize that.


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