Section II - Lesson 4
Investing Basics - Stock Investments Grow The Most
The third variable in the compound interest formula, rate of return, is the one over which we have the most control, and we should exercise this control to assure that we get maximum results from our investment program.
We may not be in a position to contribute as much as we’d like, and we may have already let a lot of precious time slip by, but we still have the power to choose the amount of “risk” we’re willing to take and the rate of return we want to achieve.
We’ll be discussing the concepts of risk and safety in considerable detail in the very next lessons, but for right now let’s talk about two basic facts. The first fact is that stability of principal and rate of return go hand-in-hand. The more stable and predictable the investment, the lower the rate of return to the investor. The less stable and predictable the investment, the higher the rate of return to the investor.
The second fact is that your overall return on an investment consists of not only the interest or dividends that you earn on that investment, but also the appreciation in value of the investment, if any, that takes place during the period of time that you own it. Your total return is the combination of these two factors.
In our book, Financial Independence 101, A Simple Strategy For Building Wealth, we present a table showing 30-year results of compounding at rates of 4%, 5%, 7.5%, and 10.5% annually.
Saving the same amount of money every year, over the same 30-year time period, the investor in a common stock index fund at a 10.5% annual rate of return would expect to earn three times as much as the investor in a money market fund at 4%, and two and a half times as much as the investor in a bond fund at 5%.
The common stock index fund investor at 10.5% would also expect to earn about 70% more then the investor in a balanced fund composed of both stocks and bonds on a 50/50 basis. This 70% difference over a 30-year period of time amounts to nearly a half-million dollars, which is a substantial sum of money.
Clearly, the type of investment that you choose will make an enormous difference in your results. The good news is that this choice is completely within our own control. Even within a company sponsored 401(k) plan that has limited investment options, there will ordinarily be a widely diversified common stock fund that comes close to our requirements.
Only widely diversified common stock funds, like an S&P 500 Index fund, provide you with a reasonable combination of high return and safety. Your money is going to work for a long, long time and the difference between compounding for 30 or 40 years at an average rate of 10.5%, instead of something lower, will be considerable.
Over any extended period in American history, stocks have outperformed all other investments. In fact, since 1926, the stock market’s worst 30-year return was almost three times as good as the bond market’s best 30-year return. Owning an S&P 500 Index fund is an ideal way to participate in this superior performance, and in the next lessons about understanding risk we'll pursue this subject further.
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