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Have you ever wondered how rich people keep getting richer and the poor can’t seem to build any wealth at all? Maybe you think it is because smart people get rich and poor people are dumb. That is not so. The rich aren’t really any better than the rest of us. They just learned at an early age the secret to continual building of wealth, compound growth.
Compound growth is the best-kept secret to the huge growth of your portfolio.
First off, you gain interest by lending someone else your money. The institution taking your money will put it to use on various projects. Because they are using your money to make more money, they pay you for the opportunity to use it. This payment is interest. There are various different places to lend your money:
- the bank
- the government
Compound growth is what we are truly seeking. Compound interest and compound growth are when you get paid interest and then that interest starts to accrue interest. This phenomenon is how the rich stay rich.
Compound growth is like an avalanche. It starts out small and then grows exponentially. When you only have $5,000 in an account making 3% annual interest, you only make $150 per year. The following year you will get paid 3% interest on $5,150 which is $154.50. However, if you have $500,000 in an account making 3% annual interest then you will make $15,000 per year from interest.
As you can see from the above plot, compound growth is not a sprint, but a marathon. You do not see the benefits quickly, but over time that lowly $25,000 we started off with became $190,000 at 7% growth. The longer it has to grow the more value it can accrue.
Why the rich stay rich
The rich keep getting richer because they have enough money growing that their portfolio growth outpaces even their extravagant spending.
Portfolio growth higher than spending is the ideal we should all strive for!
It is achievable for the masses. We can all strive to have our portfolio growth outpace our spending. If we do not spend like the rich but spend like reasonable or frugal people, then being able to live off of portfolio growth is extremely reasonable.
There are 2 ways to be able to live off of your portfolio growth.
- To lower your spending so your portfolio growth does not need to be so high
- To maximize your portfolio growth to accommodate your spending.
Actually, a combination of the 2 methods to live off of portfolio growth is the best way to go about gaining your freedom.
Where to get compound growth
Interest rates these days are pathetic! My original bank growing up offered 0.01% interest in their checking and savings accounts. This amount is simply negligible and will never make you enough money to live on. After college, I switched banks to Ally and was immediately able to get 1% interest in my savings account. Since I signed up 5 years ago the interest rate has increased to 1.05%. Nevertheless, banks are not the location to store the majority of your net worth if you are looking to maximize your growth potential.
Government bonds are also a low-interest rate environment for your funds and will not get you the growth you need to live from. The worst of all government loans is overpaying your taxes. You should strive to never have a tax refund at the end of the year because that is a free loan to the government. Not getting paid for a loan is akin to robbery! The government, especially in the US, is not the place to store your money to maximize growth.
Bonds bought on the bond market also do not get you to your end goal of financial independence. They have a growth rate of between 1-5% depending on the quality of the bonds. The ones with the lowest quality and highest chance of default are the ones that pay the highest. Basically, the ones destined to fail are the only ones that have high enough growth for your compound growth to kick in.
Stocks and the stock market, in general, is where you can achieve high growth that leads to financial independence. Historically, the stock market has grown in the 5-10% range when averaged over 10+ years. Obviously the recession from 2008 was a major hit to the net worth of many people, however, since then the rebound has come higher than we were before.
Can we trust that the stock market will return 6-8% forever? Who knows. Personally, I trust it enough to put the majority of our money in the stock market.
Stocks are a huge subject on their own. Check out these posts for more info:
Even Higher Growth?
If you want even higher growth than what is available in the stock market, there are options out there for you. Real estate has the potential to have high growth. If you can buy a house/apartment in a desirable area, you can then rent it out for a high return on investment during its lifetime. You can also buy a “fixer-upper”, do the work to get it ready for sale, and then resell it for a huge profit.
Another option for high growth is starting your own business. This has the highest growth potential of all. There are numerous success stories around the internet about how someone struck it rich with various business ideas. It is all in the realm of possibility. You just have to really want it and know that you will work your ass off for that success in your business.
For higher growth than the stock market offers, you are looking at actually having to work for your money. At the stock market level and below, income can be highly passive. Higher growth requires your work and due-diligence to create.
Compound growth is great and the higher the growth rate the sooner you will reach financial independence. The caveat in it all is risk.
Risk is the possibility that something bad will happen, and it most certainly will eventually happen. There is no silver bullet answer to the question of how much risk is acceptable. Each individual will have to answer that for themselves. Personally, I have accepted the risk of index funds in the stock market as my acceptable level of risk. However, if you feel the pull of greater growth potential and can accept the risk, then it is available to you.
With greater risk, comes greater responsibility of oversight. If you can watch and assess the risk on an on-going basis, then you will be able to see when it is time to switch to lower risk assets.
Compound growth is the answer to the question of how to achieve financial independence. With compound growth our money earns money. Then our earned money earns even more money. This cycle goes on and on to make us rich. When we can live off of the money that our money is earning, then we are truly financially independent. You can live the atypical life, a life of freedom, when you pursue compound growth.
How has compound growth supported you? Have you achieved financial independence? Let me know in the comments.