Compound Interest And The Importance Of Periodic Portfolio Rebalancing – Compound interest investments have the potential to provide profits over a long period of time, but there are several things that need to be considered, such as the importance of time, reinvestment and risk management.
Portfolio management is the ongoing maintenance of your long-term investment portfolio. This may include reviewing your asset allocation, adding new money, reinvesting interest and dividends, managing risk through rebalancing, and maintaining a long-term perspective. First things first: Long-term investors can potentially benefit from the power of compound returns (often called compound interest when it comes to bonds, certificates of deposit (CDs), and other fixed income investments). Compound interest is actually interest earned on top of interest. There are three things to consider when it comes to doubling: The sooner the money is spent, the sooner it can start doubling. Reinvestment can contribute to compound growth. Excessive risk can lead to large losses that can erode the long-term effects of compound interest. Compound interest is called the eighth wonder of the world. When you look at a graph like the one in Figure 1, the effect can be very impressive. But actually it’s just simple math. But as we will see in the next section, this may be too simplistic, meaning it does not take into account disruptions such as corrections, bear markets, and recessions that may occur down the road.
Compound Interest And The Importance Of Periodic Portfolio Rebalancing
FIGURE 1: COMPONENT STRENGTH. A $24,000 investment at a fixed interest rate yields a much higher total than when it launched 26 years ago. For illustration purposes only. Past performance does not guarantee future results.
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Compounding Basics Let’s say you have $1,000 and earn 5% per year. That’s $50 a year, right? Yes, but then it started to escalate. After the first year, you will earn $1,050 at 5% interest. Add the same 5% interest and you get $52.50 in year two, for a total of $1,102.50. In the third year, your total increases to $1,157.63 ($1, 102.50 x 1.05). Yes, the additional earnings on top of the initial $50 in interest are small at first, but they gain momentum over time. That’s why it’s important to reinvest in compound returns. If, instead of reinvesting that $50, you withdrew it and spent it on dinner at a nice restaurant, you would only earn $50 more in the second year, not $52.50 combined. There’s nothing wrong with spending money every once in a while, but when it comes to future investments, you can’t just take your profits and eat them. Managing Risk: The Law of Rebalancing Now that we’ve seen the importance of time and reinvestment, let’s turn our attention to risk. Over time, assets such as stocks or bonds grow at different rates. Bonds are designed to provide a fixed rate of return and are generally seen as less risky. The stock market has historically delivered higher returns over long periods of time, but as noted in the standard disclaimer, past performance does not guarantee future results. The stock market can be volatile, and volatility can leave you vulnerable to large losses on some assets. Let’s say you’ve evaluated your goals and risk tolerance and decided on a 50/50 mix of stocks and bonds. Figure 2 shows how a hypothetical portfolio could become “unbalanced” over time if left unchecked. Therefore, it is important to consider rebalancing your portfolio on a non-periodic basis to maintain your target asset allocation.
FIGURE 2: THE IMPORTANCE OF REBALANCE. Over a 20-year period, a hypothetical 50/50 allocation gradually becomes 69% stocks and 31% bonds. Data source: Small stocks are represented by the Ibbotson Small Company Stock Index. Large cap stocks are represented by the IbbotsonLarge Corporate Stock Index. Medium-term government bonds are represented by five-year US government bonds. It is not possible to invest directly in indices. The data assumes earnings are reinvested and does not account for taxes or transaction costs. Image source: Morningstar. For illustration purposes only. Past performance does not guarantee future results.
Note how the allocation mix changes each five-year period. A 50/50 mix becomes 60/40, then 63/37. This imbalance creates higher risk in the portfolio, resulting in greater value fluctuations in 2005. Subsequent market fluctuations will cause the equity allocation to decrease to 60% in 2010 and increase again to 69% in 2015. Note two important points in here. The actual portfolio allocation at the end of the period differs substantially from the initial target allocation of 50/50. As the stock allocation increases, the overall portfolio risk also increases. Regular Review How can an investor help control these risks and maintain a long-term perspective? Consider conducting a quarterly portfolio review to determine whether you need to rebalance your assets. Rebalancing means selling some overweight assets. These funds are then added to the underweight assets and your target allocation is returned. You can also de-risk and realign your asset allocation targets by adding new money to the portfolio. For example, if you started with an allocation of 50% stocks and 50% bonds and then switched to an allocation of 60% stocks and 40% bonds, you could direct that new money to bonds. Over time, your bond allocation will grow and align with your target 50/50 allocation. Ultimately, portfolio management depends on risk management and patience. Remember that compound interest and compound returns can be important allies in your investments. Using your money as soon as possible will give it more time to grow and recover from any downturns that occur. Watch the video below to learn more about the power of the compound.
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Rather than calculating interest over a finite period of time, such as annually or monthly, perpetual compounding calculates interest by assuming constant compounding over an unlimited number of periods. The formula for compound interest over a limited period of time takes into account four variables:
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The continuous compounding formula is derived from the formula for the future value of an interest-bearing investment:
Calculating the limit of this formula as n approaches infinity (according to the definition of continuous compound interest) yields the formula for continuous compound interest:
In theory, continuous compound interest means the account balance continues to earn interest while returning that interest to the balance.
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