The Double-Edged Sword of Compound Interest

Compound interest seems very simple but leads to unpredictable results.  What could be simpler than multiplying a sum by one plus the interest rate?  For example, to get the value of an investment of \$10 at 5% interest after the first interest is received, simply multiply \$10 by 1.05 to get:  \$10 * (1.05) = \$10.50.  To find the value after the second payment, simply multiply \$10.50 by 1.05 and so on.

The odd thing about compound interest, however, is that in just a few periods the amounts can get very big.  I remember reading in a Richie Rich comic book as a boy where Richie’s friend gave a \$5 donation and Richie Rich offered to but give only 1 penny, and then to double it each day for 30 days.  His friend scoffed that such a rich boy would only give a penny.  The end of the comic, however, shows Richie Rich handing over a check for over a million dollars.  Amazingly, if you double 1 penny just thirty times, it is over a million dollars!

When saving and investing your initial efforts seem really pointless.  If you invest \$1000 in a mutual fund and make 10%, you get \$100 for the year.  It seems like that will never grow enough to replace your \$60,000 per year income.  Keep investing \$1000 per year, however, and the value would grow as follows:

Total Investment         Interest Collected        Total Account

Year 1:           \$1000                                    \$100                        \$1100

Year 2:          \$2000                                    \$210                       \$2310

Year 3:          \$3000                                    \$331                        \$3641

Year 4:          \$4000                                   \$464                        \$5105

Year 5:          \$5000                                    \$610                        \$6715

Year 6:          \$6000                                   \$772                         \$8487

Year 7:          \$7000                                    \$985                         \$10,472

Year 8:          \$8000                                   \$1147                         \$12,619

Year 9:          \$9000                                   \$1362                         \$14,981

Year 10:        \$10,000                                 \$1598                        \$17,579

So, after just 10 years, you have increased your account value to over \$17,000 while only investing \$10,000.  Your interest payments that you are receiving are more than the amount you are investing each year.  This is where your investment really starts to grow since you interest is compounding.  After a while, it will make little difference if you continue to invest at all since the interest you are receiving will be so large.

Compounding is a double-edged, sword, however.  If you borrow money, it may seem like the interest you are paying is almost nothing when the amount you owe is small.  Allow it to grow, however, little by little as you charge dinners out and trips to the mall, and you begin to pay interest on the interest.  Even as you make payments the amount you owe just keeps growing, and it seems pointless to even make payments.

If you are paying off debt, however, and not taking on any more debt, take heart.  While it may seem that your \$500 monthly payment makes almost no dent at all on the balance when you are starting, each time you make a payment and pay off some of the balance, the interest that accrues will decrease a little bit.  Just as with the investment account where it seemed like nothing was happening and then the value started to grow like crazy, it will seem like the debt is not decreasing at all and then suddenly your \$500 payments are having a bigger and bigger effect.

Also, as you pay off some of the smaller debts, you can use the payment that you are saving to pay more on the larger debts.  You may start out with only \$300 extra available when you start each month, but if you pay off a \$200 per month debt, you now have \$500 per month to attack the next debt with.  Before you know it, you’ll be paying \$2000 per month extra on your mortgage and knocking it out years early.

Another interesting effect is when you have a long-term debt like a 30-year mortgage.  If you  pay just a little extra at the beginning, you can reduce the amount you will ultimately pay by a lot.  If you pay extra at the end, however, it has little effect.  To use this, look at your mortgage payment and see how much is principle and how much is interest.  Each time you make a payment that exceeds the amount due by one interest payment, you reduce your loan by one month.

For example, at the start of a loan a \$1000 payment may be \$970 interest and only \$30 principle.  If you pay an extra \$30 (the principle amount), or \$1030 instead of the standard \$1000 payment, that will eliminate one payment from your loan early.  This means you will pay \$1000 less than you would.  Pay an extra \$100, and you may save \$3000.  This is because you are saving 30 years’ worth of compounding interest on that extra \$100.

Near the end of the loan, you may be paying \$900 in principle but only \$100 in interest with each payment.  Making extra payments makes little difference now because you would need to make \$1900 payments to just remove one month from your loan.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Food Stocks May Be Safe Haven

Once you have invested and built up a nice nest egg, attention turns from growth to stability.  It’s nice to have some nice little growth stocks that can grow 1000% over then next several years, but having a portfolio full of them can mean quite a wild ride.  Looking at the January 25th edition of Value Line, which included the Food Processing Industry, presents some nice picks to add stability to a portfolio.

Once of the standouts was McCormick & Company.  You know, the company that probably has a row of spices in your supermarket?  Selling parsley and basil may not seem as exciting as creating the next social networking site, but there are a lot of people who buy spices regularly.  Earnings have been growing at a respectable rate of about 10% per year, and the stock has been on a slow and steady uptrend since 2009.  With a 2.1% dividend, and a dividend growth rate in the 10% range, this might be a nice stock to balance out a set of growth stocks in a portfolio.

Another stock in the same group is Nestle SA.  This stock trades as an ADR (American Depository Receipt, which trades like a stock on the US exchanges and tracks the value of the European company).  Nestle makes more than just hot chocolate.  They make Gerber baby food, Poland Spring bottled water, Nescafe coffee, Dreyer’s Ice Cream, and Stouffer’s frozen meals.  Even if there is a slowdown in the economy, expect consumers to keep buying these old favorites.  The ADR pays a 3.3% dividend which is also growing in the 10% range.

Finally, Tootsie Roll company makes virtually every well-known candy on the market, including all of the Tootsie products, Andes Candies, Double Bubba Bubblegum, and even Junior Mints.  The price of the stock is as flat as a board, but it pays a 1.2% dividend and its earnings are expected to grow by about 10% per year after declining over the last several years, so it may be due for an uptick.  Even in a recession, you would expect people to keep buying their old favorite candies.

None of these stocks can be expected to suddenly shoot to the sky – the rate of earnings growth is too slow and they already have such a large market it is difficult for them to grow further.  Still, they are steady producers that provide a nice dividend at a time when banks are paying nothing.  One can also expect the value of their product lines to grow with inflation, so owning shares fo the companies is a good inflation hedge.  These may be worth a second look as an addition to a large portfolio.

Follow me on Twitter to get news about new articles and find out what I’m investing in.  @SmallIvy_SI

Disclaimer: This blog is not meant to give financial planning or tax advice.  It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA.  All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

Stock Picking 101: Why High Beta Stocks Have High Returns

One factor to consider when picking stocks, particularly when picking stock for the long-term, is to choose stocks that have a higher beta.  Beta is a measure of how volatile the stock is when compared to the market.  Basically a stock that has a beta of 1.00 will move around (have a variance, for those statisticians out there) about twice as much as the market in general.  So if the market has 10% swings, a stock with a beta of 1.0 might be expected to have 10% swings in price as well.  A beta of 2.0 would be twice as wild as the market, and one with a beta of 0.50 would be half as spastic.

The beta of a stock can change with time, with older, established companies having lower betas than newer companies.  This is because their earnings become more predictable, they start to pay a dividend which also adds stability, and because they have more business lines that tend to counter-balance each other.  The beta of a stock may also change for a period of time if there is quite a bit of uncertainty around it for some reason, such as take-over rumors.  Finally, stocks in some industries, such as internet companies and biotechs, will have higher betas than those in other companies such as banks and utilities.  Again, this has to do with predictability of earnings.

Stocks with a higher beta carry more risk.  If a stock may go up or down by 50% over the year, you could lose 50% of your money fairly easily.  If it only tends to fluctuate by 10%, chances are your losses will be lower, given a stable market.  Note that there is no certainty – well established, stable companies run into trouble as well.  Sometimes they become complacent and newer competitors steal their market share.

Because they are more risky, high beta stocks carry a lower price than low beta stocks for the same predicted earnings.  This is because people are willing to accept a lower return if there is lower risk.  Conversely, if people are taking a bigger risk, they want to make more money when things work out to cover the losses in the times things don’t.

Remember, however, that time and diversification both reduce risk.  It would certainly be very risky if you were buying stocks and holding them for a few month or maybe even a year to buy high beta stocks.  Virtually everything known is already priced into the stock – anything you can figure out, others can figure out as well.  If you are buying high beta stocks it is really a coin-flip whether they will go up or down, and they will go up or down a lot more than low beta stocks.

Likewise, if you are buying one stock, your chances are a lot better that you will pick a stock that will grow over time if you pick a low beta stock with solid, predictable earnings growth than if you buy a high beta stock with earnings all over the map.  If earnings don’t materialize you could see a drop in the price and then see the stock sit there for years as the company recovers from its missteps.

If you are buying for the longterm, however, you will see better returns from high beta stocks.  You won’t necessarily know when great earnings will come in that will cause the stock to shoot up, but over long periods of time earnings will grow faster than they will for established companies.  If you are willing to wait patiently, the odds will catch up with you and earnings will rise.

If you are diversifying, you can also afford to buy more volatile stocks.  If you buy ten stocks, while you may have one that simply dies and another two or three that don’t make much progress, one or two winners that grow tenfold can make up for the laggards.  Because they are priced so that, on average, an investor will make a large enoguh profit on the winners to justify the additional risk, if you buy enough different stocks to reduce your exposure to any one position, you should get a better average return than you would have in low beta stocks.

One of the best and simplest ways to take advantage of the high beta advantage is to weight a portfolio heavier in small and mid-cap mutual funds.  There will certainly be times when large caps will do better, but over long periods of time the small and midcaps will do better since their earnings will grow faster and there will be a risk premium  – a reduction in the price due to the additional risk – included in their price.  As the amount of time you have to invest grows shorter and your tolerance for risk declines, money should be shifted into large caps and lower beta investments such as bonds.  When you have years to invest, however, and can put up with the gyrations, higher betas are the way to go.