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One of the most interesting things about investing is the way that you can earn solid returns through the power of compounding interest. Indeed, as Prieur du Plessis points out on Paul Kedrosky’s Stock Market Returns blog, even Albert Einstein recognized the incredible power of compounding interest, calling it the eighth wonder of the world.

What does compounding mean?

Basically, compounding means that you earn interest on your interest. When your returns are compounded, it means that your returns are added into your principal, and then you earn further interest on the total.

Many people think of compounding in terms of credit cards. This is how credit card companies keep so many people in debt. However, there is a very positive aspect of compounding: as a way for you to increase your earning power through investing.

The secret to compounding: time in the market

Those who use the power of compounding to their advantage do so by making long term investments. Index funds, some mutual funds, solid value stocks and even some cash investments can help you earn a steady income, and enjoy compounding returns over decades.

Earning returns this way — through compounding — has nothing to do with “timing the market.” Those who try to time the market, trading more frequently and aggressively trying to make larger returns, often find their returns eroded by taxes, commissions and other fees. Additionally, it is difficult to consistently time the market is such a way that one regularly beats the market.

For most people, a steady, solid investing strategy involves long-term investments that take advantage of compounding returns. While the returns aren’t huge — right around 7% annually, they are often consistent. And if you keep your investments for two or three decades (or longer — start investing young!), you are likely to find yourself with a tidy nest egg.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions.

Tags: stock market, compounding returns, investing blog, Albert Einstein,
index funds, investments, compound interest

Over the past couple of weeks, we’ve been looking at the principles in The Four Pillars of Investing by William Bernstein, using a post from Get Rich Slowly as a guide. So far, we’ve looked at the theory of investing, history of investing and the psychology of investing. Today’s topic is understanding the business of investing.

Pillar Four: Business of Investing

One of the things that many investors do not pay much attention to is the way investing — as business — works.  I like that Bernstein gives readers a course in how investing works in business terms. And, of course, the point of a business is to get your money. The investing industry is no different in that regard. Fees and commissions are designed to earn money for brokerages, mutual fund administrators and other money managers.

Another interesting point that Bernstein makes is that there are other forces at work that can deplete your earnings: inflation and paying attention to sensationalist stories in financial media.

Inflation is the obvious culprit. It erodes your earning power and reduces your returns.  Media sensationalism is a little less obvious. Get Rich Slowly describes it thus:

Meanwhile, traditional financial journalism tends to hype hot mutual funds and brokerage houses — spreading what some people call “financial pornography” — in order to boost sales.

This is an interesting point. After all, the herd mentality often leads one wrong. It is often best to consider market performance and fundamentals, rather than rely on talking heads and “experts” whose main purpose is to garner ratings.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions.

One of the fears I hear regularly is that with stock market volatility — and other upheavals in the investing world — that investing is “too risky” or “not smart” right now.

It is true that some types of investing may not be the best idea right now, especially for beginners. But investing is still a smart choice. It is important to use investments to allow the law of compounding interest to work in your favor. You just have to be careful about what you invest in.

Stocks

If you choose carefully, picking fundamentally sound value stocks, you can actually find some great bargains right now. Buying more while the market is mostly down on most days can mean great gains down the road. Index funds are another way to get into stock investing without exposing yourself to excessive risk (although that risk will always be there). Mutual funds can also offer stock investing diversity with lower risk than individual equities (but watch out for the associated fees).

Bonds

These are considered “safe” investments — when they are government bonds. Federal bonds regularly grow, albeit at a rather stodgy rate. However, they can make good investments in terms of safety, and they generally do better as the economy falters. For better returns (but greater risk) corporate bonds and municipal bonds can be invested in.

Currencies, Commodities and Futures

Currencies are rather risky. When you get involved with FX trading, you should have a high risk tolerance. It is possible to make quite a lot of money on the currency market, but it requires some practice and the ability to take chances with your cash.

Commodities and futures are also quite risky. These require knowledge of markets and savvy decision making. Any number of factors can affect how commodities and futures move, and it is important to know what you are doing and to have a high risk tolerance when you engage in commodities and futures trading.

Disclaimer: I am not an investment professional. Nothing in this piece or on this Web site should be construed as investment advice. Before making investment decisions, do your own research and/or consult with an investment professional. All investment comes with the risk of loss. You are responsible for your own investment decisions.

Tags: stock market, currency market, investing blog, index funds,
futures trading, investments, FX trading