Wednesday, January 28, 2009

Einstein: the miracle of compound interest

Albert Einstein thought compound interest was more miraculous than E=MCsquared!

To compound your money into a fortune, you need four things:
  • Compounding takes time. The more time you give it, the more money it'll generate for you. This is why it's so important to teach your children about compounding. Time is the driving force.
  • You need commitment. Compounding is boring. It requires no trading, predicting, or risk taking. That's because there is no risk. Most people don't have enough self-control to let their investments stand for long periods of time.
  • You need to save. No one likes to save money... especially 19-year-olds. But for compounding to work, you need to save money from a young age.
  • Finally, you need a safe investment that generates interest, dividends, or retained earnings. Small increases in yield turn into huge increases in fortune when you compound over many years.

This is the advice I give to my 22-yr old College senior about to enter the working world for the first time. This is the investing technique I try and follow myself.

Its quite good advice. People like Buffet, Gates, Sam Zell all made fortunes much bigger this way.

Right now, the government is doing everything it can to prevent you from using this amazing technique. It cut interest rates to zero. It's inflating the money supply, which undermines true interest rates. And it would like to raise tax on dividends and interest receipts.

Sheesh! what to do?

Fortunately, there are still ways to make compounding work for you. Take advantage of 401ks, IRAs, DRIP plans, and tax-sheltered investments like MLPs. They'll defer your tax liabilities until you're finished compounding.

Look to the stock market for safe, high-yield investments. The financial crisis was a huge stroke of fortune for young income investors. The safest municipal and investment-grade corporate bond funds are paying yields over 10%. The riskier ones will pay you over 20%. You can make 20% income by selling covered calls on the strongest American blue-chip stocks. Even boring pipeline investments pay 10% dividend yields.

My children...

If you want to be rich, you should build a portfolio of these safe, high-yield investments, shelter them from tax, add to your account every year, and let your earnings compound for 40 years. You'll easily accumulate a million dollars, and probably a lot more...


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