Updated: Apr 24, 2020
His exact words were, “Compound interest is the 8th wonder of the world. He who understands it, earns it…He who doesn't, pays it.”
On the surface this sounds just like any other cute Instagram quote that we’d instantly flick through on our way to another cat video. Hit the pause button...are you sure you realize what he’s saying and why he’s saying it? More importantly, are you aware of what incorporating those words into your financial life actually looks like? Lastly, have you seen an example of compound interest in action? Because…
The difference in a few percentage points on what your investments earn can completely change your financial future.
In order to understand what he’s talking about, what is compound interest? Compound interest is simply the earning of interest on upon interest of an investment. Here is the most basic example: If I invest $1,000 at 10%, at the end of the year I’ll have $1,100. If I keep those funds invested, I’d have $1,210 at the end of year 2. That extra 10 dollars, is what Einstein is talking about. In the early years of compound interest working, it doesn’t make much of a difference. But towards the later years;
Compound interest makes all the difference in the world.
Let’s dive a little deeper. As employees trading our time for money, we typically contribute to a deferred compensation retirement plan. The actual fund we’re invested in is either centered around an asset class such as ‘Large Cap Value Fund’ or a target date fund such as ‘2035 Fund’. Over the long term, the compound annual growth rate for the S&P 500 is 9.05%. Which means that on average your deferred comp account will generally perform at that level or less. I say less because if you are in a target date fund, your plan manager will slowly transition your portfolio out of stocks in the S&P 500 and into bonds. This is a risk mitigation strategy as it trades riskier stocks (aka higher variability of returns) into bonds (lower variability of returns).
Sidenote, if you’ve ever wondered why that is, it has to do with US bankruptcy law. If a company goes under, the debt positions (bonds and loans) have a higher priority of claim to any liquidation proceeds compared to any equity positions (company stock). Debt holders are paid before equity holders - which gives bondholders a higher probability of recouping capital during a bankruptcy.
So back to your deferred comp account, that transition out of stocks and into bonds comes at a cost, and that cost is returns. So while the S&P 500 will return you 9.05% over the long term, your target date fund will most certainly return less than that. Let’s put it on a graph.
This graph uses a generous 10% and 6% for the long term returns of the Stock Market and Bond Market respectively. Any target date fund will fall somewhere between the two. This chart assumes an initial $50,000 investment with no additional contributions & compounding at the shown rates. This may or may not be a realistic scenario for you depending on what your personal financial picture looks like. For one thing, not many of us start with 50k, and also the vast majority of us will continue to make additional deposits. No matter what your personal financial picture looks like,
There is one take away from this graph that is extremely important: The rate of growth in the final years.
For a 50k investment growing at 10%, after 30 years that grew to nearly 800k. But look at what portion of that growth occurred in the final 5 years: Nearly 300k (800k - 500k) or almost 40% of the total growth occurred in the final 5 years. THAT is what Einstein is referring to - the power of compounding interest.
There are 2 factors we can control to influence our personal financial picture: Time and Rate. Investing as early as possible is most important - the longer that money is working for you, the earlier you will start to see that exponential growth in the later years. But seeming as how we can’t go back in time and change what we did in our early 20’s, the next best thing we can do is to change our rate. And that is accomplished through which asset class we choose to invest in. Now you didn’t think you’d get this far into an article of ours without hearing about which asset class we favor did you? Yup, here’s the pitch and it comes in the form of a graph as well:
Again, we chose a conservative 16% for a commercial multifamily growth rate. Our projects have an average projected IRR of of 20.2%. Diversifying into real estate will achieve significant long term growth for your overall retirement & investment portfolio. This is due to 3 unique aspects of real estate investing not found in the stock market: Leverage, Value-Add, & Taxes.
Leverage: Real estate by nature is a leveraged investment, we use a relatively small down payment to control an asset valued at 4-10x that amount. Yet the returns we achieve are based off the total value rather than the down payment value. Its an advantage unique to real estate.
Value - Add: When was the last time you called Coca-Cola, Apple or Tesla and suggested they change their distribution and manufacturing pipeline? As a minority shareholder in a stock, there is simply nothing you can do to add value to your investments. By investing in a value-add real estate investment, the general partnership is actively adding value to your investment through renovation and repositioning.
Taxes: Aside from the depreciation & expense deductions inherent in real estate investing, there is another very important tax implication. Yes, your deferred compensation funds are growing tax free in your 401k or 457b plan ( sidenote: so are your real estate investments in a 1031 exchange). But stop for a minute and ask yourself what tax rate you’ll pay come retirement. Bingo: Deferred compensation distributions are taxed at your ordinary income tax rate (22-35% for most of us) versus a commercial multifamily investment which is taxed at the capital gains tax rate (15%).
Einstein knew what he was talking about, and it's much more than a cute quote from history. He is advising all of us to pay attention to compound interest because of the significant impact it can have on our lives. Time and Rate are the 2 factors affecting overall returns of an investment taking advantage of compound interest. Rate being one factor we can change today. Commercial multifamily investments offer significant advantages when compared to investments in the stock market. Leverage, the ability to add value and important tax considerations are a few reasons why diversifying into real estate makes sense.
Invest with fyre CAPITAL
fyre CAPITAL is a commercial multifamily investment firm. We purchase and/or partner in 150-600 unit, value-add apartment communities in fast-growing Tier 1 & 2 U.S. markets. Together with our strategic partners, fyre CAPITAL represents over 500 Million Dollars of successful real estate acquisitions. Our developers, sponsors and capital partners have amassed a network of over 1,500 unique investors. We provide new opportunities to invest in projects targeting a 14%-21% Internal Rate of Return . If you would like to join us on our next project, your first step is to Submit an Interest Card. We look forward to partnering with you.