Written By Kyle J Christensen, CFP, Feb, 9, 2022
Financial advisors constantly use compounding interest calculators (“Time Value of Money calculators”) to project and predict future values for their clients. The problem with that is that stock, bonds, and mutual funds don’t compound interest. In fact, no investment does. This usually comes as a shock to most people within the financial services industry, and they immediately become defensive. Before you do the same, consider what compounding interest actually means.
This is compounding interest: Suppose you have $100 that you put into an account that pays an interest rate of 1% per year. At the end of the first year, the balance would be $101. Now you’ve got $101 earning 1%. By the end of the second year, your balance would be $102.01. By the end of the third year, the balance would be $103.03. And so it would go with compound interest. What investments do that? None.
Stocks don’t compound interest. They appreciate and they depreciate in value. That’s not the same as compounding interest. The value of a cow appreciates and depreciates. The value of a house appreciates and depreciates. The value of gold and silver appreciates and depreciates. None of those things actually pay an interest rate that compounds. What about dividends? What about them? They don’t compound either. If a company declares a dividend on a stock, it’s a one-time payment (paid out quarterly or annually usually). It doesn’t compound. There isn’t even any guarantee that there will be a dividend at all the next year. What if you reinvest those dividends? Ok, then you are buying more shares of stock. It’s still not compounding interest. It’s the same with cows. Cows can have more cows. Does that mean cows compound interest? If course not. Now, because all financial institutions want to keep our money as long as possible, they will do whatever they can to convince us not to take out our money, but instead “reinvest” it. However, that is not compounding interest.
Why the fuss about compounding interest? Because when advisors use compound interest calculators to show their clients what their mutual funds, stock values, and retirement account values will be in the future, it is fundamentally wrong. It’s sort of like saying the sun revolves around the earth because it appears to be that way. It’s fundamentally wrong, and it leads people to believe things that aren’t true.
Sure, we can use compounding interest calculators to figure out the equivalent compounded rates of return that would have been required for something to grow from where it was to what it is now, but to say that the stock market compounds interest is completely false. And to use calculators, by the same fashion, to show people what they will have in the future, is also completely false. As an economist and mentor that I knew often said, “The only thing right about projections and illustrations of future values is that they are all wrong.”
Understanding this truth also sort of demolishes the entire use of the phrase, “the miracle of compound interest” (supposedly by Einstein), as it relates to investments. It’s simply not applicable. Compound interest calculators, therefore, are generally used as a marketing tool to sell investments. They are not real predictors of what is going to happen and are generally a bad way to choose an investment. Calculations and projections are not a good substitute for real knowledge about an investment.
