Why Compound Interest will Kill You
Investor education usually starts with the “Magic Penny”. The goal is to demonstrate the power of compounding interest by asking students whether they would choose a penny that doubled in value every day for 30 days or $1 million. The “correct” answer is the penny. By the end of a month, it will be worth more than $1 million. Now I have nothing against compounding growth rates. It’s the only way to make serious money. The problem is that people think that’s the cure all without seeing its limitations.
To see the limitation in this thinking, let’s say that you did start with a magic investment that doubled in value every year, but you could only invest one penny to start. At the end of 30 years, you would have over $1 million. Not a bad retirement, if inflation doesn’t eat it all. But you won’t be buying an NFL franchise with that money. In fact, you could hardly buy a McDonald’s franchise with that money! So the #1 lesson of compounding interest is that it matters how much money you start with. Basically, the only way you can get compound interest to work for you is if you are rich to start with.
So starting with a penny isn’t going to work. What about that 100% annual compound return. Guess what, that doesn’t exist either. Not in finance at least. Even Warren Buffett can’t beat the market these days. The only way you can get that kind of compound growth is by finding a product that you can easily scale. That’s why companies based on intellectual property are so valuable. They might be capital intensive to start, but once they find a market, they are easily scalable. Industries that meet this criteria include media, tech, and pharmaceutical companies.
Then you have to figure out how you’re going to run your business. Once you put up your initial investment, your working capital goes from 100% cash to whatever your return is. If it’s 20% then you only have 20% to work with. Your best case scenario is that it will take at least 5 turns of your investment to get back to your original working capital. That’s why inventory, or capital, turnover is so damn important.
In the end, you probably won’t win the lottery and you will want to enjoy some financial freedom, and the most reliable way to do that is through compound interest. But there is no silver bullet, no “magic penny”, so we are stuck with trying to achieve a compound growth rate despite its drawbacks.