The Wisdom of Compounding Interest

The strongest force in the universe, according to arguably one of the most brilliant minds ever known, Albert Einstein, is Compound Interest.

If there’s one lesson to draw from investing and growing wealth, making “time” work for you. Investment is a job for the long haul; revising strategy every time markets act awry will kill your wisdom and money.

But the investor has to bear the risks of loss and depreciation. Often investors get apprehensive about how erratically the market behaves, about the high-handedness of investment gurus, jargon, and almost always, how compounding works.

To put it into perspective, Warren Buffet’s wealth plummeted from $62 billion to $7 billion in 2008 during the sub-prime crisis. This goes to show that when markets self-correct, it affects the giants and small investors alike.

Let’s see what compound interest is and how it affects your portfolio.

Compound Interest is the amount you earn on your earned money. Interest on interest earned. Time and interest rate are the key factors at play here. Generally, the more time money is given to growing, the more it multiplies over and above itself. How does it multiply? By reinvestment. When you reinvest the interest earned, to earn interest on that reinvested interest, that’s when you unfold the magic of compounding. By contrast, debt also multiplies if compounded.?

To paint a simple picture - when you earn positive interest on your positive balance kept in savings or investment account - you’re presented with two options - either reinvest the interest or not. Once reinvested, this interest grows over a period of time and compounds to create wealth. It is this exponential growth of compounding that builds successful businesses and meaty portfolios.

One may notice how market volatility in 2020 has shuddered investors, and they’re taking cover under Alternatives for investment. What makes Alternatives as a strategy and asset class click is their ability to perform differently than traditional instruments. But they’re also notorious for exclusive access to High-Net-Worth individuals and entities, falling into two main types - Private Assets and Hedge Funds.

Private assets include private equity, private credit, private real estate, currency, infrastructure, and commodities. This private asset class is known for its complexity, so it is not as frequently traded as public stocks and bonds. However, they add additional sources of return to the portfolio.?

Hedge funds, as the name suggests, are primarily bought for hedging against investment risks. These usually employ less-used investment tools such as short-selling and leverage to earn returns.?

Here’s what you should keep in mind while building a successful portfolio in Alts -?

1. Stock Market trends don’t affect Alts.

Anyone looking to turn to Alts must have experienced the roller coaster that a stock market is. One day you’re gaining and the next day your portfolio drops. As you near your retirement age, the risk appetite for such a volatile wealth-building venture naturally reduces, so much so that you look for diversification. Not only that, a recent survey by iCapital Network of top U.S. investment gurus revealed that diversity and attractive returns are the two key reasons why investors switch to Alts.

But don’t make the mistake of thinking REITs as publicly traded investments will give you the benefits and returns of Alt; they’re not. They’re just as volatile, if not more.

A far safer bet to hedge against the unpredictability of stock markets is to go the private investment route. For example, if you hold a real estate asset and rent it out, you can be assured of a mortgage or rent annuity, no matter how the market behaves—this type of private real estate investment vis a vis REITs.

2. The primary reason why one needs to understand the power of compounding to earn wealth deeply is to avoid the pitfalls of volatility and let the magic unfold for at least three decades.

Let me demonstrate -

Let us assume you can go either of two ways with your $1,00,000 invested for 30 years.

Case #1: You let your $100,000 ride the stock market roller coaster for 30 years, bearing losses and making significant gains. All in all, garnering an average return of 10% p.a.

Case #2: You earn a simple, straight and predictable 9% every year—no ups and downs.

This is how your $100,000 will look like in 30 years:

Case #1:

Case #2:

A plain return of 9% compounded over and over without market volatility gives you at least six times greater return than a volatile higher rate of return. Now we know why it is crucial to avoid the pitfalls of volatility to harness the power of compounding.

3. Tax Benefits

Whether you’re a seasoned investor or not, tax benefits accruing to private equity and other private investments in Alts are too shiny to ignore. Two upfront tax benefits are Carry-Over Depreciation and Long Term Capital Gains (LTCG). It is a practice with real estate funds to reduce the net taxable income amount by depreciation (a non-cash expense). Likewise, long-term capital gains are treated with favourable tax rates vis-à-vis short-term gains. To add to that, Oil and Gas Investments have a favourable depreciation treatment.

To conclude, Alt investments may seem like the panacea to the volatility of stock markets and aid in compounding, but they must be taken with a pinch of salt. One major drawback with Alternate Private Investment is the lock-up period of at least 3-10 years. The investment amount stays locked for the said period, as liquidating the amount would liquidate the underlying asset.

Alternative Investment routes work great for any individual or entity that wishes to diversify without bearing the unpredictability of large caps and mid-caps.

Considering the risk appetite, stage of life, priorities, and financial goals - different Alt strategies will bring solid returns and aid in compounding the wealth.?