The Greatest Discovery of the 20th Century
Albert Einstein is often quoted as having said that the greatest discovery of the 20th century was compound interest. There's no evidence that the story's true, but it's a fun anecdote, nevertheless, and it 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 $17,126 (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 369%. In other words, instead of earning $17,126 in interest, you would earn $63,281.
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 $187,155. Thus, three times the rate produces nearly 11 times the return. And at 20% — a four-fold increase in rate — your profit would be $518,275, or a return 30 times higher than that provided by 5%.
Investing monthly works just as well as 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 304%, just as before. At 15%, you would have earned $125,724; at 20%, you'd have earned $286,965.
I taught personal finance 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 offers you 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 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 this to be true for decades. Back in 1993, a study in The Journal of Financial and Quantitative Analysis showed 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.
Sometimes the effects are even shorter. A 2007 article in the Quarterly Review of Economics and Finance found that on-air buy recommendations on a popular cable investor show boosted stock prices, but all the gains were captured by the next day's opening price. More recently, a 2009 study in The Journal of Financial and Quantitative Analysis found that the effect of media coverage on a stock's performance wore off within one or two days following the news publication.
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.
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 — see Chapter 38.)
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. (Now you know why I stopped teaching there — I resigned in protest after being on the GU faculty for nine years.)
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 website, or in my seminars. Be wary of those who do. Like all investment advisors, we at Edelman Financial have our 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.
The above examples are for illustrative purposes only. They assume no withdrawals or fees.