Long Term Investments – Power of Compounding

It’s an age-old question with a simple answer. The best time to invest is in the past.

Now, that’s a somewhat challenging answer, considering the fact that none of us can go back in time and do things differently. Yet, this one lesson is helpful in reframing the way you think about investing today.

What makes the past such a great time to invest? First, the market has historically trended upwards over time, and second, the magic of compound interest. Compound interest means that you make money on your principal investment plus the interest you accrued.

Say for example you invest $100 each month for 10 years, with an annual return of 6%. In 10 years you would have $33,300. That’s $24,200 in principal and $9,100 is from interest. Since the amount compounds over time, investing early and consistently can make a huge impact when it comes to long-term investing.

Want to see for yourself? Plug some hypothetical values into a compound interest calculator.

Why is the market so volatile?

The only thing as certain as the stock market’s historic upward trend is its historic volatility. For example, in 2018 we saw swings in which the Dow would go up 500 points one day and then down 500 the next. The statistics suggest this volatility will continue well beyond 2019. That’s not because we’ve entered a new era; it’s because the market is always volatile.

From month to month for decades at a time, the market fluctuates three to four percent. The only difference now is the magnitude of the fluctuations. In the mid-1990s, a 300-point move would represent a 6% fluctuation, but since the Dow currently rests around 26,000, a 300-point shift is 1%. But, again, that’s normal.

There are some positive effects of market volatility. Volatility shakes the sheets of short-term speculators who provide liquidity but don’t make long-term investments. This really hardens long-term investors and rewards them over time (since it’s time and not timing that provides a good return on investment).

Moreover, a volatile market keeps investors from falling into complacency. It’s also often an expression of a company’s value more accurately reflecting its actual value as opposed to being artificially inflated by the enthusiasm of investors.

So, expect volatility, but don’t just ride it out. Make adjustments.

Why timing the market doesn’t work

No one can predict the market with enough accuracy to consistently make a profit. So while there are trusted experts who are known for strategies that consistently pay off (Warren Buffett comes to mind), there is no way for any of us to predict exactly what the market will do at any point in time.

What is “timing the market?”

To time the market is to attempt to live by the maxim of “buy low sell high,” which is the thing that everyone is trying to do all the time, yet failing to do consistently.

What’s the alternative?

Consistently keep investing and you’ll profit in the long term. That’s because the one thing that’s certain is that the market trends upwards. In fact, if you stopped investing during downward trends you’d lose money because those downward trends are short-term compared to the larger history of the market.

Is time or timing more important in investing?

Most of the time, time is more important than timing. There are of course plenty of examples where people have gotten lucky simply by having great timing. That said, investors most consistently “win” through steady, long-term investing strategies that ride the fluctuations of the market over time.

Enduring the ups and downs

Over the course of history, the stock market has moved upward. But that doesn’t mean that there have never been catastrophic depressions and recessions. These events can have a very significant impact on investors’ day-to-day lives, so much so that it might seem like there is no end in sight. Being a long-term investor means having the stomach to ride out these fluctuations, especially the lows, which can test your faith as an investor.

The power of compound returns

Does this look familiar: $100 invested once a month for 10 years with an annual return of 6% earns you $33,300. Out of that sum, $24,200 is from your principal and $9,100 is from interest. That math was used to illustrate the power of compound interest, but what it failed to show was the effect of the market’s dips and gains. That takes an emotional toll on many observers, so you had to be prepped for it with plenty of talk of the market’s historic upward trend.

A closer look, however, would reveal plenty of setbacks and much nail-biting. Some years the baseline of your investment would be greater than previous years and some years the baseline would be lower. But over time you would recover and make gains. A look at the stock market over time is evidence enough of that claim.

Compound Interest

How long is long enough?

Start by building an emergency fund. Three to five months of living expenses that you will strategically keep on the sidelines. Once you’ve built that up, you can start to think about your financial goals. Are you saving for retirement? By when would you like to retire? Are you saving up for a home? How many years from now would you like to make that purchase? As you can see, your investment approach will vary based on your individual goals.

In general, if the financial milestone is short- or mid-term, a more conservative approach might make the most sense. You will assume less risk, with less potential upside, but that will get you closer to your desired outcome in the time frame. If your milestone is decades away, retirement being a common example of this, then you might opt for a riskier portfolio that has more time to sustain the fluctuations of the market over time.

Should I adjust my 401(k)?

Adjusting your 401(k) entails balancing the ratio of stocks to bonds relative to your risk tolerance. Some experts suggest doing this once or twice a year. This can be done either with a professional or on your own. How do you know if you can do it on your own? Explain your plan to someone else. If they understand you then you make sense. If not, then a professional’s advice may be worth the investment.

Your risk tolerance is how much money you can actually afford to lose. Some factors that influence risk tolerance include current debts, age, health status, and any other life events that may impact your ability to take on risk (e.g. starting a family).

Your life circumstances may be such that more bonds serve your best interest simply because you can’t risk your savings because you may need them sooner rather than later. Alternatively, you may be able to ride out some volatility for a while, which, given the market’s historic upward trend, may ultimately help you achieve your goals.

When now isn’t a good time to invest

If you haven’t created a budget, stocked up an emergency fund, and tackled your immediate debt, then you might want to hold off on investing at this moment. You may also want to hold off if you have not yet determined your financial goals, and milestones for which you plan to invest.

If you have these foundational pieces in order, however, then it might be a good time for you to start investing. Apps like Public make it easy to start, providing access to 1,000s of public stocks and ETFs that are available for purchase in slices.

Pam Velazquez is Senior Marketing Manager at Public.com.

The above content is provided is paid for by Public and is for general informational purposes only. It is not intended to constitute investment advice or any other kind of professional advice and should not be relied upon as such. Before taking action based on any such information, we encourage you to consult with the appropriate professionals. We do not endorse any third parties referenced within the article. Market and economic views are subject to change without notice and may be untimely when presented here. Do not infer or assume that any securities, sectors or markets described in this article were or will be profitable. Past performance is no guarantee of future results. There is a possibility of loss. Historical or hypothetical performance results are presented for illustrative purposes only.