Section II - Lesson 2
Investing Basics - The Power Of Compound Returns
The projections that we looked at in the lesson on visualizing results illustrate what we can achieve when we set out to maximize the power of compound returns.
We do this by earning the highest possible rate of return, over the longest possible period of time, on the most amount of money we can make available for investment.
Compounding comes about from the interaction of money, time, and rate of return. How much money? How long? What rate of return?
All three of these variables influence the magnitude of our results, but the impact of each differs significantly from that of the others.
The three variables also differ with regard to how much control we can exercise over them. We may not be able to do much about how much money we can contribute every month, for example, but there’s a lot we can do about finding a desirable rate of return.
If we wish to maximize investment results, we need to take some time, at this point, to analyze the role and the influence of each of these variables and understand how each contributes to our overall investment results.
It may surprise you to learn that the least important variable in the compound interest equation is the amount of money you contribute. The impact of this variable on total results is what the mathematicians call “linear”, meaning that its impact on results is directly proportional to the amount of money you contribute to the program.
This is to say that if you double the amount of money that you’re putting into the process, you’ll double the amount you end up with. If, instead, you put in half as much, you’ll end up with half as much.
The impact of the other two variables, time and rate of return, is not linear and therefore more important to your strategy.
What this says to us in regard to maximizing our own investment program, is that saving 12% in our two accounts is probably good enough. It’s not that advantageous for us to strap ourselves further in order to contribute more.
While it would be nice for us to end up with more money later on because we were able to increase the amount we were saving every month, this is not nearly as important as taking maximum advantage of the other two factors, time, and rate of return which we will study in the next two lessons.
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