Understanding Losses: Compounding Interest

Posted on: April 30th, 2014
Most investors are familiar with the magic of compounding interest but they often fail to realize that when the portfolio loses money, the math of compounding works against them. That's because when a dollar is lost, it is not just a dollar but a compounded dollar that is lost, so the investor must regain more just to break even.

The Key Takeaways
o Compounding interest works for the investor when the portfolio is making gains, but works against the investor when losses occur.
o When minimizing losses in your investment and trust portfolios, your wealth compounds from a higher floor and this is the key to long-term wealth creation.

How Compounding Works For You
Compound interest is calculated on the principal and accumulated interest. Here's a simple example of how compound interest works:

Investment Interest Rate Interest Earned Total
Year 1 $10,000 7% $700 $10,700
Year 2 $10,700 7% $749 $11,449
Year 3 $11,449 7% $801 $12,250

The benefit of compounding interest makes it important (and attractive) to invest for the long term. For example, if you continue to earn 7% interest each year, at the end of 20 years your $10,000 investment would grow to $38,697.

How Compounding Works Against You
If you have a loss, compounding interest makes it difficult to catch up. For example, say you lose 7% the first year. To recover the loss and get back to the original investment of $10,000, it would take you until sometime in Year 3 at 7%.

Investment Interest Rate Interest Earned Total
Year 1 $10,000 -7% -$700 $9,300
Year 2 $9,300 7% $651 $9,951
Year 3 $9,951 7% $697 $10,648

But that is not really break-even. To recover the 7% loss and catch back up to the benefit of compounding interest, you would have to have a 23% return in Year 2 to reach $11,449. It's a basic algebra formula: $9,300 x N = $11,449. Divide both sides by $9,300 to solve for N. Answer is 1.23...or 23%.

This is why it's critical to minimize losses.

What You Need to Know
As losses become greater, so does the reverse compounding. With a 10% loss, the investor must gain back 12% to break even. With a 20% loss, the gain must be 25%. With a 50% loss, the investor needs to earn back 100% just to break even.

Actions to Consider
o Work with your investment advisor and trustee to minimize losses in your taxable portfolios and any trusts you've set up.
o Examine other ways you may be exposing your wealth to unnecessary risk. For example, having adequate insurance will prevent you from having to use your wealth to cover any uninsured losses.
o Work with an estate planning attorney to minimize losses from court interference at incapacity and death, unintended heirs, unnecessary taxes and fees, and to protect your assets from lawsuits.
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