Have you ever seen a flock of birds in the sky when they are moving back and forth as one entity, changing shapes and direction, almost fluid? If you haven’t seen it on a David Attenborough show, just take a look for yourself:
Though it is totally captivating, it is practically impossible to predict the direction that the flock will take next. It would be ridiculous to even attempt to pick, let’s say, the five strongest and quickest birds that are darting around somewhere within the flock.
The typical investment ‘earn a quick fortune’ self-help influencer will say “you can totally pick those five birds using my formula, here’s how you do it for the low price of $197”. Don’t believe me? Watch a few YouTube videos about investing and see what ads pop up. Usually a common thread among them all is the message that the eighth ‘Wonder of the World’ is the phenomenon known as ‘compound interest’ and as long as you understand this miracle-worker, you’ll be well on your way to Scrooge McDuck levels of wealth.
So what is compound interest? How exactly does it work? Perhaps most importantly, how could it lose you money?
Compound Interest
Definition – The interest earned on the initial deposit plus the accumulated interest from previous time periods.
Confused? Back to our chaotic flock of birds to make sense of this.
You decide to place wagers (over five rounds of betting) on what you perceive to be the five strongest and quickest birds out of the flock. For this to work, you believe you can even predict when your chosen birds are going to slow down or become ‘weaker’ in comparison to the others in the flock. This is vital if you want to be rich because just before a bird slows down, you’ll dump that bird in favour of a new one; a better, stronger, and quicker bird – yes, I know how that sounds!
By consistently placing wagers on what you perceive to be the strongest and quickest birds each time, and using the winnings to make larger and larger bets, you will increase your earnings exponentially (with a bit of luck). That is how compound interest works in the stock market. Here it is in bird form because I find this funnier:
Note: I was very against including numbers in this edition to begin with but it is important. Take the time to fully understand how the initial £500 has increased in value across the five rounds. It might seem a little confusing at first, but stick with it and you’ll understand something that many others do not (and yet compounding interest is something we are all affected by).
Compounding Bird Bets
Summary: At the end of each round, you took your total winnings and divided it all on new bird bets in the following round, compounding your total winnings. In five rounds of accurately betting on the best birds in a compounding scenario, you have turned £500 into £805.25.
In comparison, let’s take a look at what happens to your £500 in a non-compounding scenario (in short, this is where you don’t reinvest your winnings).
Non-Compounding Interest
Summary: Only £500 is wagered in each round, the winnings are pocketed across the five rounds. In the non-compounding scenario, you have turned £500 into £750.
The difference in the end results may seem small but the more times you compound your ‘winnings’ and the more money you put in, the difference in results can be shockingly high. So far, compound interest looks more appealing, doesn’t it? However, if my crazy bird betting analogy made any sense whatsoever you might already have a sense of what is to come.
Here’s how you lose your money
Hero to Zero
Stocks and shares are the riskiest of all asset classes. Any business can have enormous success, or they can face a major setback such as enter administration, be involved in a scandal, the list goes on. Remember those birds you perceived to be winners? They may turn out not to be (if they haven’t already). There are so many variables to consider. It is impossible to predict what will happen with certainty. It is pointless to pretend. It is vital that you know the true value of any stock can be reduced to zero, unlike many other assets. This means that if you have compounded your money and are investing it all, you can make a fortune (if you are lucky). However, at any moment, you could lose it all. There is a complete spectrum of possibilities and both extremes are possible, but not equal in probability. The compounding effect only really works if you can consistently predict and pick the winning birds!
You are not Jordon Belfort (Wolf of Wall Street)
Professional investors such as ‘day traders’ use their expertise and sophisticated computers to make large trades on tiny changes in stock prices each day. They benefit the most from the compounding effect, reinvesting their gains day after day, but instead of trading hundreds it might be millions of pounds. This is why stocks and shares can be so appealing. Trades can be made as frequently as you like. You have the absolute freedom to lose as much money as you like and as quickly as you like. In contrast, seeing any growth in your standard savings account takes much longer because the interest is paid out only once a year and typically with a far lower (yet more stable) rate of return. The interest rate on a typical savings account is currently 0.1%, Feb 2021. Be aware that the low rate of return from a bank is designed to incentivise many of us to look elsewhere for alternative ways to increase our wealth. Picking individual stocks and shares should not be your go to.
Buckle up for a rollercoaster
‘The Economic Cycle’, ‘The Business Cycle’, ‘Boom and Bust’, ‘Bear and Bull’ – however you choose to refer to it, economists have spotted a repetitious pattern of ‘the good times’ and ‘the bad times’ that dates back pretty far. Yet still, one of the most common questions asked on any forum is; when is the next ‘bad time’ coming (you know – the crash, the recession, the dip, the bust, the bear market)? When exactly is it going to happen? Unfortunately for many reasons that I’ll cover another time, ‘when’ cannot be accurately predicted. Yet many investors believe they possess the power to see into the future. This can lead to an over-confidence in believing that the good times will continue, and a lack of awareness of just how unpredictable the bad times can be. 2007 appeared to be an amazing year for the world economy – a ‘perfect time’ to invest everything. But those who were overconfident in the market, and invested beyond their means, probably lost more money than most.
By now you’ll know I love a good analogy, so please forgive me for indulging one last time. Imagine being blindfolded on a rollercoaster that is heading upwards. The sensation of being pushed back in your seat tells you that you are on an upward trajectory. You might start to sense that this feeling may not last forever. Now all you need to do is predict (down to the millisecond) exactly when the rollercoaster will plummet, whilst blindfolded. That is how difficult it is to predict ‘when’ the next dip in the cycle will be.
Here’s how to invest a bit more sensibly.
If you are determined to get involved in stocks and shares you might want to explore a Stocks and Shares ISA. You pick your preferred level of risk and the money is invested for you for a tiny fee, usually into a fund that covers hundreds of companies, indexes, bonds and commodities. Firstly, they have many tax advantages meaning less tax is shaved off any gains. Secondly, if you humbly accept you are not the Wolf of Wall Street and keep your money in this type of ISA for a minimum of 10 years (and top it up consistently) you should get a return that’s pleasing to the eye. Most importantly, you will not be as exposed to ‘weak birds’ and you’ll be able to ride out the ‘bad times’, if you hold on long enough.
Note: It is important to note that any investment can increase and decrease in value (to below the value of your original investment). Only invest in stocks and shares if you can afford to lose money, only invest in stocks and shares if you are prepared to leave your money for years and years without withdrawing anything.
No birds were harmed in the making of this edition.
The Tulip Teacher 