Seeing speculative bets work out as expected is the best thing an investor can get—but sometimes, this is not the case. It’s mentioned in these pages over and over again: when an investor takes short-term speculative trades, they are exposing their portfolio to a significant amount of risk, which can be dangerous for those who are close to retirement or are saving for it.
Those who are involved in the world of investing for the long term should do just that—focus on the long term and use time to their advantage. Staying in the markets can be painful to some due to the noise and volatility on a short-term basis, but the gains on an investor’s portfolio can be phenomenal over the long haul.
With the help of one investing concept and solid growth companies in their portfolio, investors can save up a significant amount of money for the time when they need it, be it retirement, travel, or their child’s education. Investors who want to invest for the long term should equip their investing knowledge with the concept of “compound interest,” which Albert Einstein called “the most powerful force in the universe.” (Source: “Albert Einstein Quotes,” ThinkExist.com, last accessed May 28, 2013.)
Simply stated, compound interest is when an investor earns money over what he or she has already accumulated. This concept may sound a little confusing at first, but it can make a portfolio grow exponentially over time.
To make the concept clear, consider this scenario:
Say, for example, you have $10,000, and you put this amount into a savings account that pays you two percent interest per year, compounded annually. By the end of the first year, your account will have $10,200—this is simple. Now, in the second year, your investment will grow to $10,404. Note that in the second year, the interest given by the bank was the same, but your investment grew at a faster pace; the actual rate of increase per year was 2.02%. In the third year, the investment will be worth $10,612.08, and so on.
This is, of course, a simple textbook example. Investors’ portfolios are generally spread across stocks and bonds. As it may not appear, stocks provide investors with the same benefits of compounding interest. Consider this: you have a stock portfolio of $10,000. If it goes up by five percent in the first year, and then 10% in the second year, what will your portfolio be worth at the end of the second year?
By the end of the first year, your stock portfolio will be worth $10,500, and if it grows by 10% the next year, it will actually be worth $11,550. Therefore, the return would actually be 15.5%, compared to just an even 15%.
Investors should never forget this rule of compound interest: the longer the investor has and the bigger the rate of compound interest, the faster the portfolio grows.
If investors use solid growth companies that provide dividends in their portfolio and hold these companies for some time, they can reap significant rewards. Their gains may look good at first while staying short-term, but in the long run, they can do much better without risking a lot.