The Financial Industry's Biggest Lie About Compound Interest

They say that compound interest, it's the eighth wonder of the world. Yeah, right up there with vending machine sushi and gas station sashimi. You know, sounds great until you realize it's been wildly oversold. Here's the twist. Compound interest. It does work, but the way Wall street sells it to you, it's like being promised a yacht, but then they hand you a pool noodle with a dream. Here's the thing. In this episode, I'm going to bust the biggest myth financial industry ever sold you. And that is time alone will make you rich. We're going to unpack the difference and why average returns and actual returns are different and how it can wreck your total portfolio. We'll talk about the deceptive, smooth curve of compound interest and compound growth. And I'm going to look at the real risk hiding in timing, AKA sequence of returns. All right, here's the problem with the compound interest fantasy. See, the financial industry loves to parade around. Compound interest is like the miracle cure for your money problems. Now, I believe in compound interest. I love compounding. I think it's great. But we have to have a perspective about it. We've got to understand how it works and how to get it to work for us. And they say, well, just invest a little every month and boom, you're a millionaire. Well, it sounds easy enough until the reality hits in like a surprise CrossFit class. I mean, come on. Yes, compound growth is powerful. It's possible, but it takes time more than people want to give it. It takes consistency, even when you don't feel like it. It takes discipline to not touch the money when things start to get messy, and they will get messy. That's just the way life is, and that's just the way the market is. And most people will literally lose faith in year five.

Why?

Because it's not skyrocketing. Because there's this curve that goes slow at first. In fact, I'll draw this out for you. I call it in my book the wealth creation curve.

And when you look at the wealth creation curve, it looks like this. And it goes up fast, okay?

But it starts off really, really flat.

And there's a section of it right at the very beginning that is flat. And I call that the wealth flatline. And. And this is something that we're not prepared for.

They don't tell us about it. But what happens is, you hear people like myself that says that, say, hey, just. Just invest. Just keep investing and keep going. That's the right advice, but we need to temper it. With an understanding of what to expect, okay? Because at the very beginning of your wealth journey, it's like watching paint dry on a glacier, but then it speeds up later, okay? Because in, in this time frame, what's happening? And I've had this happen where people.

Look at me and they go, mel, I am listening to you. And I keep putting money and money and money and money and money and money in.

And after five, six years ago, I made $67. You're a fool. What you talk about doesn't work. Ah, it does. But here's the challenge, is that we don't tell people that there's the well flatline. It's why I wrote about it. I want people to be aware of what to expect in those beginning years. Because the well flatline, that beginning portion, is a situation where you're actually compressing a swing, a spring. You're just compressing a spring and it's growing, growing, going, and all of a sudden you're going to release it. See, your wealth creation is not linear. It is exponential.

But the only way it gets exponential.

Is you have to get through the wealth flatline. And the only way to get through the wealth flatline is time and consistency.

Because on the other side of this, on the other side of this, the wealth flatline, you can see that it.

Goes up in an exponential rate because.

That'S where your acceleration zone is.

This is where in the subtitle of my book, this is where your money is working harder for you than you did for it.

Okay?

So the first thing to understand about compounding, interest and compounding is that it's not linear. And at the beginning, it's going at a snail's pace, but it's doing its job. You're compressing a spring that when it releases, it's going to rock it.

Okay?

Because when you get to those later years, all of a sudden, the amount of money your machine, your money machine is making far exceeds the money that you can generate through your personal efforts. That's the gift right now. There's some other things that I think we need to understand about, about compound interest and how it's measured and how it's looked at. And that is something that is the difference between average returns and compounded annual return or annual annual growth.

Okay?

A lot of people, including myself, will talk about the average returns of the market, but if we only look at the average returns of the market, when I talk about average returns of the market, I do it because it's easier for people to understand. But when I analyze and work with clients. We then break it down into more detail and look at the compounded annual returns, because that is more of what's going on. Here's what we know. The market doesn't go up in a consistent fashion. It goes up, it goes down. It's all over the place. And when you look at an average, it's just that it's an average. And I'll give a very, you know, extreme example, but let's assume that, that you have two years of a market.

And in year one, you make 50%, okay? It was a good year, 50% up. And then you get to year two, and in year two, you lose 50%.

It was a bad year in the market. Here's the thing, is that if you.

Look at this, the average return, the average return of this is, is 0%.

Okay? Because plus 50, minus 50 divided by 2, okay? Plus 50, minus 50, 0 divided by 2 is 0, okay? And so you think that everything is fine, right? And you get that. But let's look at the math. Let's go deeper on the math. This is where you start to. It starts to really make sense and go, oh, wait a second, it's not the same.

So let's assume that you start with $1,000, and in that first year we go up 50%, okay? So now you're at $1500.

So you're now at $1,500.

And then we get to year two, and year two, we go down 50%. Okay? So we go down 50%. That $1,500 suddenly becomes $750, okay?

So if we look at it this way, then what really happened?

What really happened? Although we say here that the average return is zero, the real return here is a minus 25% because you went.

From $1,000 to $750, so you lost 25. That's the difference between average returns and compounded annual growth in an extreme example. But the fact is, is that, that if we're not careful, we can think that the average returns are the gospel. And in extreme situations, it becomes financial gaslighting. We need to be aware of it. The average return is literally like, like sitting back and saying, I'm in an ice bath on one, on my lower half body. I'm in a sauna in my upper half of the body. On average, I'm warm. Doesn't work that way. Okay, it doesn't work that way. So what we really want to do is understand what that, what that compound annual growth rate is because we lost 25%. Now, in order to do that, there's a calculation to get to compound annual growth.

I'm not going to, I'm not going.

To bore you with it, but the compound annual growth is literally going to look at the difference between the $750, the $750, and the thousand dollars over two years.

And ultimately this translates over a two year period as losing 13.4% per year.

A minus 13.4% per year. So in one case, the average is zero. In the reality, you lost 13.4% per year. Okay, why does this matter? Because retirement plans, investment projections and everything, glossy fund ads often talk about average returns, which is fine, but I want you to start asking the questions. And also look at the compound annual growth returns. Markets are volatile. Volatility breaks, compounding.

Okay?

If Marcus just did this, it wouldn't be an issue. But a 30% gain doesn't cancel out a 30% loss. It leaves you behind.

Okay?

So that's why we teach people to look at the real numbers. We'll start with averages, but at some point we'll look at things and say, let's look at the compound annual growth and do some realistic stress testing because some of the averages aren't going to pay the bills. All right? But cash flow does. Let's make it done right. Now, the other part of, of compounding that we don't talk about or they don't tell you about, and, and it's a sneaky, sneaky thing. It's this wealth assassin that we just don't, don't think about. And that is this idea of what's called sequence of return risks. Now, as you're building your wealth, it doesn't really matter as much because you're not drawing down the portfolio, you're not doing things in it. But, but it, if you start to draw down the portfolio. And when I remember when my father retired, okay, he retired and he had his 401k, he had his pension, and literally the year after he retired, the market tanked and it stayed down for a couple years. And what it did is it didn't destroy his retirement. It certainly had a material impact, let's just say, all right, because all of a sudden his, his portfolio of assets that he was going to retire on went down. Now the challenge is that if we aren't careful and we haven't built a plan in place to understand and take into consideration margin for volatility, margin for sequence of return risks, in other words, early losses in the early years of retirement, the drawing down of that portfolio is going to have a material negative impact on what you do.

And so it's important for you to start to look at that. And I have an example that I'll walk you through. And I did it on another video, but I think it warrants really understanding how this plays out.

Okay, and that is this. Here's what sequence of return risk looks like.

We take two people in the exact same portfolio. They start, they start with a million dollar portfolio and they, they have the.

Exact same returns year by year, but the returns are reversed. So you look at this one and.

In the good years first, so they, they have a big return, big return, they have a negative, then they have good returns and they have a negative.

Okay, we reverse that in the second.

One where we start with a negative, then small return, decent return, negative. And then the big returns are at.

The end that million dollar portfolio because of the sequence of returns, the million dollars. In example one, the person that had.

The good returns first, that million dollars, goes to 956,000.

The second one where they had the.

Bad returns first, that puts the portfolio at $877,000.

Okay, it's an almost an $80,000 swing. Okay, 8% swing. Now that's over six years. Extrapolate that over a longer period of time. The point being is this, is that the sequence in which the market goes up and down actually matters. Because it's not the same number every single year. We need to be mindful of it because if we're not careful, in one case someone can exhaust their portfolio, in another case they can have another decade or more to work from. So, and here's the interesting thing. The average returns for both of these examples are exactly the same. And that just has to do with the way the average is calculated. So it's something to be really careful about and understand that. So how do you fix this? And I think that this is the thing to, to think about is that we don't rely on averages alone. We track real returns. We use compound annual growth and we stress test the plan. We do it at least annually. I do it more than that because I'm checking it all the time because I'm a numbers nerd. But you know, what matters is what actually hits your account. And if one year is 20% up, in the next year's 20% down, you know, they offset in averages, but they don't in reality. So, so one is to, to, to not rely solely on averages. Number two is to build flexibility in your plan. Build Flexible income. This is where the whole idea of money machine comes in. Building a money machine at a level that you have margin for volatility, that means that you have diversified income sources, dividends, interest and other income streams that you can, you can work from. It's also why the wealth priority ladder is so important. It's, you know, I talk about my putting a safety and an unshakable foundation in first. The first two phases of the wealth priority ladder is about creating a financial foundation where you don't have to, to take things at a loss. That means you're building liquidity, you have a comfort fund, you don't have destructive debt, and you have your peace of mind fund. I want that peace of mind fund pushed to nine to 18 months, especially as you get out there in years. Because if there's a market downturn and you have the liquid cash to sustain yourself, you don't have to take a loss on the portfolio. You can allow it to recover while you're working on that. So we need the flexibility in doing that. Number three, I want you to use buckets or time segmentation. I want you to look at things and say my early retirement years need to be in a low risk asset bucket. In other words, that first three to four years in low risk assets, that's going to be high yield, cash counts, bonds, things like that, bond ladders, CD ladders, things like that.

Okay?

Because I don't want to take that, that money, the short term money, on a roller coaster ride. Then I'm going to have a midterm bucket that's four to three to seven, eight years and then I'll have everything else long term. Okay? So that's number three. I'm going to break it down to give me flexibility. There's number four is to watch out for fees. Now I pay fees to my wealth team and it's well worth it.

Okay?

But it's because they do way more than just pick investments. You know, we work together and we do a lot of other things. But at the beginning, until you have critical mass or you have complexity or you have nuances that you have to plan for, you probably don't need some sophisticated wealth team or, or advisor in there because you can build a 1, 2, 3, 4 fund, maybe 5 fund portfolio and allow it to run.

Okay?

And as much as you don't think that a 1% fee sounds like much, it'll lead up to 20 to 30% of the portfolio over time because it's a compounding thing.

Okay?

So this is the thing that we want to look at. It's how I would look at it. I think that compound interest is amazing. Compounding is amazing. It's not a scam. But the way it's marketed as the absolute can. Can feel like a real con when you start to understand it. But now that you understand it, now that you have a perspective, you can look at it in the right context and know what it's telling you and.

How to use it to your advantage.

And what to expect. Because if you want a real shot at building wealth, then you need more than just time. You need clarity. You need a plan. You need guts to stick with it when the market throws a tantrum. And it will. And that's what this show's about. That's what building your money machine is all about. So listen, if you found this helpful, then do me a favor. Hit the like button, hit the subscribe button, and share it with someone you care about, okay? Let them know about it. Let's give them access to this. Because I'm on a season of service. I want to help people find that path to financial freedom, just like we have and just like many of my clients have. Okay? I'm on a crusade to do that for a million families, and I want one of them to be you. All right?

Until I get a chance to see.

You on the road to your financial freedom. As I always say, always, always strive to live a life without lose you. I'll see you next week. Thank you for listening to the Affluent Entrepreneur show with me, your host, Mel Abraham. If you want to achieve financial liberation to create an affluent lifestyle, join me in the Affluent Entrepreneur Facebook group now by going to melabraham.com group and I'll see you there. And that's it for this episode of Building youg Money Machine where we help you learn how to master your money, eliminate financial stress, and live a life of choice. If you found this valuable or helpful to you, here's what I'd love for you to do. If you do me a favor, go to Apple, Apple Podcasts, or wherever you're listening to this podcast and rate and review the show. It helps us tremendously to keep us at the top of the list so we can continue to get this information and this message out to people. Because I truly believe that financial freedom is your birthright and I want to help each and every one of you claim it. Thanks so much.