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How the Greatest Discovery of the 20th Century Can Make You Rich

From The Truth About Money

Albert Einstein is often quoted as having said that the greatest discovery of the 20th century was compound interest. Of course, the story’s not true, but it is a fun anecdote that makes a good point.

Here’s why: If you were to invest $10,000 at 5% interest for 20 years, your profit from the investment would be $16,533 (ignoring taxes). But if you doubled the rate of interest to 10%, how much money would you earn?

Although it would seem that doubling the rate would double the return, this is not the case: Increasing the rate by 100% increases the return by nearly 350%. In other words, instead of earning $16,533 in interest, you would earn $57,275.

That’s the power of compound interest: Money doesn’t grow linearly -- it grows exponentially! Take it a step further: If you earn 15% instead of 5%, your profit would be $153,665. Thus, three times the rate produces more than nine times the return. And at 20% -- a four-fold increase in rate -- your profit would be $373,376, or a return 23 times higher than that provided over 300%.

Investing monthly works just as well when investing a lump-sum: If you invest $100 a month over 20 years, you’ll have invested a total of $24,000. At 5%, your money would earn $17,103 in interest, but doubling the rate to 10% would once again increase your profit by 350%, just as before.

At 15%, you would have earned $125,724; at 20%, you’d have earned $286,965.

For nine years, I taught a class on this subject at Georgetown University, and it was usually about this time that my students would raise a question: Where can you earn 20%?

The Secret to Earning 20% with No Risk

Would you like me to tell you how to earn a guaranteed 20% per year with no risk? Well, I’ll tell you:

I don’t know how.

And if I did know how, why would I tell you?

Ask yourself that question the next time someone cold-calls you with the hottest deal around. After all, if they have such a great investment, why would they tell you about it? Look, I’m a nice guy, but let’s face it: If I had a “sure thing,” I’d be so busy investing my own money that I certainly wouldn’t have the time to tell you about it. And assuming I did have time to make a few phone calls, why would I call you -- a total stranger -- instead of telling my family and friends?

Actually, Wall Street has pondered the question of “why tell me?” for some time, and identified two theories: The first says that the only sure way to make money from investments is to earn commissions by selling them, and brokers can do that only by convincing someone that he or she will get rich in the process. Thus, this theory says a broker tells a client to buy or sell because it’s good for the broker, not necessarily good for the investor.

The second theory says that Wall Street sharks who are on TV, the radio, or in some magazine or newspaper telling you to buy a certain stock often already own it, and they want to unload it. But they can’t sell until the price goes up, or up again, and what better way to get the price of a stock to go up than by telling a few million people to buy it? So, they tout the stock on CNBC or Wall Street Week or Money magazine, and the masses oblige.

The stock briefly goes up -- long enough for the guy who pitched it to get out -- and he goes back on these programs to say, “See? I was right!”

Wall Street is full of these self-fulfilled prophecies.

You think I’m kidding? Studies have shown that in the 48 hours after a stock is touted on a popular TV show or news column, the stock rises significantly as tens of thousands of people call their brokers with buy orders. The run-ups last just long enough for the sharks who fed the information to the media to cash out at big profits. After that, the stocks quickly return to their original levels, leaving investors with stocks they bought at very high prices.

Consider the example of Kidder Peabody broker A. Karl Kiplee. According to Financial Planning on Wall Street, Kiplee admitted that he planted inaccurate stories in the media about Epitope, Inc., a small biotech company. Allegedly, he gave CNBC and then-Money magazine reporter Dan Dorfman (perhaps the best-known financial journalist in the nation at the time), false information, causing Dorfman to report in March 1994 that Epitope’s AIDS test stood only a 1% chance of receiving FDA approval. This allegedly caused the stock to drop in value, yet in December of that year, the test was indeed approved.

Epitope, alleging false and misleading statements, settled a suit with Kiplee, and even considered a suit against Dorfman, merely because Dorfman quoted Kiplee. As Dorfman later told Business Week, one “just can’t be sure that everyone [you] speak to is 100% ethical.”

But that wasn’t Dorfman’s only brush with controversy. Business Week reported in late 1995 that Dorfman was under investigation by federal authorities regarding his relationship with a Wall Street publicist. According to Business Week, the allegations were that corporate clients paid fees to the publicist, a good friend of Dorfman’s, in exchange for having Dorfman say positive things about the company. There is no indication that any money was exchanged between the publicist and Dorfman. However, Dorfman was fired by Money magazine; and he later left CNBC.

Think this story is dated? Then consider the more recent accounting scandals that have implicated dozens of companies and their auditors and the brokerage firms that promoted their stocks to hapless investors. For a complete discourse on this, read Chapter 6 of Discover the Wealth Within You.

Think about it. Stock prices are based on the laws of supply and demand. Supply (the number of shares of a stock that exist) is fixed; thus the price goes up and down based on demand. If lots of people want to buy, the price goes up, and if few want to buy, or if many want to sell, the price goes down.

Match these fundamentals with how one succeeds in the stock market. You make money by buying low and selling high. First, you buy a stock that has a low price. Then you go on television or radio, or get quoted in the newspaper, telling everyone that the price is really low and that you think the price of the stock is going to go up. Better yet, get someone like Dorfman to do it for you.

By distributing your message to millions of people, several hundred thousand will oblige, and this new demand will cause the price to rise within a day or two. You know when the show is going to air, or when the story is going to be printed (since you planted it), so you buy a few days in advance, and after the news breaks, you quickly sell while the stock is high, making a bundle. The masses, of course, get ripped-off: They buy the stock after the news report, as the stock is on its way up (they BUY HIGH) and as soon as the media attention ends (which it does quickly) demand softens and the stock falls back to its original level, causing them to SELL LOW. Thus, the knowing-no-better consumers lose money while the promoters make money. This becomes a vicious trap for the unwary, because the promoters return to the media, saying, “The stock went up, so I was right. Therefore, you should listen to me next time and do what I tell you to do.” Thus, they get invited back onto these shows, and they can be quoted again and again, and people continue to follow their “advice” and unwittingly help them make millions time after time. (This is one of the reasons why there is often a big difference between investment returns and investor returns).

Several law school students at Georgetown University figured out how to engage in this “pump and dump” scheme on the Internet, and they bilked investors nationwide for hundreds of thousands of dollars before the SEC forced them to stop. But the university allowed them to graduate anyway, and today they all have law degrees. (And that explains why I stopped teaching there -- I resigned in protest.)

So whenever you see a “hot tip” touted in a financial newsletter, magazine, or newspaper, or you hear some pundit claiming on radio or TV, or on some Internet site, that you need to buy or sell a certain stock, you’ve got to ask yourself, “What is the motivation of the person who’s saying this?” After all, how relevant to your particular circumstances can the advice be when it is simultaneously being provided to millions of people?

Keep that in mind the next time you hear some financial wizard say, “The market’s going to have a 20% correction.” He might really mean, “The stock market’s too high right now for me to buy more, so I want you to sell your holdings, which will force the stock market down by 20% so I can get in at the lower prices.”

This is why I never tout stocks, mutual funds, or other investments by name in this or any of my books, or in my newsletter, on my radio and TV shows, on my web site, or in my seminars. Be wary of those who do. Like all investment advisors, I have my favorites, but my role here is to provide you with a fundamental financial education, not to get you to buy or sell something. By focusing on education, you’ll understand how the financial world works, making you able to make decisions that are best for you. And that, in turn, will allow you to take control of your financial future so you can ignore all the pundits.

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