I’m sixteen years old and I want to build up a stable investment foundation. I’m not looking for financial advice, I’d just like to know how compounding interest works.
I’ve been looking at things like managed funds which say they offer 12% annual interest rate. If I was to reinvest every year I would experience exponential growth in say, 40 years. Is it possible for these managed funds to underperform and completely ruin my investment? I was also curious if things like index tracking funds and ETFs offered similar compounding possibilities?
In: Economics
First, I highly suggest subscribing to /r/personalfinance and reading the FAQ of that subreddit.
> managed funds which say they offer 12% annual interest rate
What product offers this? It sounds too good to be true.
> If I was to reinvest every year I would experience exponential growth in say, 40 years
I think you are confused about a couple terms.
– “Exponential growth” means “increases by a percentage every year.”
– “Reinvest” usually refers to using dividends from an investment to buy more.
> Is it possible for these managed funds to underperform and completely ruin my investment?
Underperform? Yes. Completely ruin? It depends on what is meant by “ruin.”
> if things like index tracking funds and ETFs offered similar compounding possibilities?
Yes.
There’s really no reason to invest in managed funds. Managed funds charge high fees, but a lot of studies have shown they don’t outperform index funds with much lower fees. A company might have dozens or hundreds of managed funds. By chance some of them will do better than others.
You are mixing up terms. Interest rates are set payments for borrowing or lending money. Funds that invest money offer rates of return, but those are not guarantees—only historic track record.
They cannot offer compounding interest since they aren’t offering interest. But what most offer is dividend reinvestment, where any dividends earned get plowed into more shares or more money reinvested into the fund.
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No managed fund can guarantee 12% annual returns.
But “compound” interest is the interest you make on interest.
If you invest $100 and get a 10% annual return, you would have $110 at the end of the year. If you did not put in another dollar and waited another year you would have $121 next year.
That’s another $10 in interest from the original $100 and $1 from the $10 in interest you earned last year.
Gaining interest on interest is how you get rich
A good guideline in the investing world is that 10% returns will double your money every 7 years.
Not ten years, like makes sense on the face of it, that’s the beauty of the compounding. Every 10% gain gets folding into the total every year, so you get the doubling much faster than if you were just taking those 10% gains and setting them off to the side somewhere.
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