Throughout my career I’ve learned a lot about the financial world. I came to find out that there are many things which are upheld as “sacred cows” of finance, that typically underperform and are overhyped, but at their worst can be detrimental.
And so when compound interest comes up and most people tout its benefits, I’m inclined to disagree. In fact, I’ve become convinced it is slow, dangerous, dogmatic and overall, well- compound interest mostly sucks.
What is this heresy? The financial pundits herald compound interest as this ingeniously wonderful thing, and many of us just accept that it is some sort of money-making miracle. Well, let me kill this sacred cow for you and save you both time and money through a safer and faster alternative way to wealth.
Let’s identifying 5 problems that illuminate the errors and detriments of compound interest-
It Neglects Cash Flow
Compound interest usually has people over-emphasize net worth. We’re taught “good things come to those who wait”, and so people wait for 30 years. We are trained, taught and educated to dollar cost average by putting money away every month regardless of performance. We are told that in the “long haul” we will buy at an average rate and the market will go up and down, but will ultimately trend upward over time. Are you reading this article to be average or get an average rate? There is a difference between average and actual first of all. If you invest 100,000 and lose 10 percent in the first year, you have 90,000 dollars. If you gain 10 percent in the second year, you are now back at a 0 percent average return, but you are only at 99,000 dollars before expenses, plus you lost time value of money. When you invest for cash flow, you can measure success month-to-month along the way. No more shirking responsibility in the name of “one day, someday”- but benefitting from it now.
High Risk Doesn’t Equal High Return
Compound interest is fueled by better returns. Wall-street is constantly selling the idea of taking on more risk in hopes of a higher return. But what is the definition of risk? Chance of loss. How by increasing your chance of loss and waiting longer are you assured of more wealth? This faulty notion continually promotes taking more risks than necessary in the name of aggressive, opportunistic returns that invite volatility.
As an entrepreneur you take risk in your business. But you have control to make changes anytime, to stop funding projects or marketing campaigns and learn from your mistakes. Why not consider creating personal wealth with your business by using more risk-free capital. Investing while protecting the downside, creating cash flow along the way, and creating economic independence rather than waiting thirty years for compound interest to do its job.
Fluctuating Tax
We’re actually historically low with taxes right now, but there was a long period- from 1944 to 1981- where the top tax bracket was over 50%. If you are using tax deferred accounts to compound your interest, you may end up paying more tax during the distribution phase. With the government over 23 trillion in debt, what are the chances taxes could go up in the future? This can be especially problematic if you sell you business and lose one of your greatest resources for legally reducing taxes. Plus, when you are on a fixed income in retirement, living off just your interest, especially in a retirement plan that hasn’t been taxed yet, this could really diminish and invade your cash flow.
By maximizing your tax advantages today and building cash flow along the way, you have more control and options in a changing environment. You might pay tax on some of the money along the way now, but at today’s rate instead of a potentially higher rate in the future. Oh, and that myth that you can live off less money in the future, inflation alone is proving that philosophy wrong. One thing I have discovered is that a luxury becomes a necessity. Do you really want to have less money in the future in the name of saving on tax?
Inflation and Changing Interest Rates
Low interest rates are one of the most dangerous components when it comes to compound interest. People that have saved a million dollars or more for retirement are not living the life of luxury. It has been an amazing environment for those business owners that want to secure funding through loans. Interest rates have remained low for a few decades. But for those that have saved for retirement, fixed income interest rates have been astonishingly low. Creating plenty of net worth that hasn’t equated to much cash flow. One million dollars may be providing 40,000 dollars or less, taxable.
And the truth is we have no idea what we’ll actually need to save to provide the income we want. Our money is being devalued through inflation at this very moment. And what we feel might be a good target, we find out years later isn’t going to allow us to live the lifestyle we may have hoped or planned on, because now we have to have more money. And if interest rates are low, it’s harder to have that become cash flow.
The solution? Invest in your business. Turn your non-cash flowing assets into a powerful stream of income. Save on tax, interest, and insurance. Eliminate non-performing investment fees and protect the downside with all your investments. Look to be more efficient with your money and scale your business to create compounding you can count on.
It Takes Time…A Long Time
How long are you willing to wait? Because compound interest doesn’t work well over 10 years, and it isn’t even that good over 20. Where compound interest really gets the kind of exponential growth is around 30 years. Compound interest makes you wait for so long that you don’t even know how if it’s working. Much of that time entrepreneurs are taking money from their business by scrimping, sacrificing, saving, and setting money aside to invest in the stock market that they don’t know or control. This is done with the rationale of once “you get there” and retire, you are supposed to have a “nest egg”. But why not invest that money into your current endeavors and ventures so you don’t have to wait until retirement to build more cash flow and equity in what you know- your business?
Compound Interest Equals Compound Cost
When compound interest does work over long periods of time, it is halted when there are costs that create drag and slow down progress. You may be paying admin and legal fees for a retirement plan or expense ratios and 12B-1 fees to market the funds you bought (yep, you pay those). Small percentages create compound costs.
Those are just a few problems with compound interest that can be solved with an alternative method to investing- your business, cash flow, and not being solely focused on net worth.
Compound interest has masterfully disconnected to the outcome of their income by teaching them to buy, hold and pray it works out 30 years from now.
Scrimping, saving, and just hoping compound interest will do the work has been a failed financial experiment. Think ‘win then play’ by making money on the buy, create cash flow from the very moment you invest, and look for ways to benefit from your wealth today and in the future.