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Thinking About Rate Of Compounding

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July 28, 2008 – Comments (10)

I was reading an article about Warren Buffett's thriftyness that pointed out that when you can compound savings at 25%, every dollar you save turns into a lot of money over a couple of decades. And that thriftyness makes sense when you think about it. I'd have saved harder and earlier if I could grow the money like that. My own rate of savings has gone up as my compounding rate has improved. (And thanks to The Fool, it has improved!)

Then I got to think about negative compounding rates and suddenly something that has puzzled me for years was explained. I've noticed that my poorer friends have a tendancy to spend any windfall chunk of money quickly. One took an inheritance and opened a book store. (That went under in less than a year, leaving her in debt.)  Another took a dot com payout that conservatively invested would have paid for a cushy retirement (it was about 4 years salary and he has another 30 years to work) and bought trucks, cars and a larger house with it.I've discussed this phenomina with a friend who is a pastor in a church that has a lower working class membership and the behavior is painfully common.

Now, one of the things that got drummed into my head, early and often is "Thou shalt not spend capital". So this behavior has always been alien to me. Windfalls are to be saved and invested, no matter what.

 But now, suppose you have a negative compounding rate. Any capital you get will be whittled away at by sudden expenses and needs. So you have to spend it quickly if you are to feel like you got anything for it. There was a Sanford and Son episode that had exactly this pattern. Fred won a big payout playing the numbers and various relatives showed up with sob stories. The rest was stolen by a robber pretending to be a newspaper reporter. At the end, the only thing Fred had to show for it was a suit he bought right when he got the money.

Wishing you all good compounding,

Chris 

10 Comments – Post Your Own

#1) On July 28, 2008 at 10:13 AM, GyroDynasty (98.73) wrote:

I think that if you have a good interest rate and a collection of stocks that have both high dividend yields and high dividend growth, that your compounding becomes very powerful because you're constantly fueling the machine.  I know that time is the #1 factor, but the dividends can really push your savings to another level. 

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#2) On July 28, 2008 at 11:00 AM, khrushchv (< 20) wrote:

I've often wondered about this behavior too...The one smart thing I've seen people do with windfalls is buy firearms...they often hold their value well and, sometimes, appreciate...

I have seen some ideas floated that "playing the numbers" could be framed as a type of saving behavior...Suppose tickets cost $5 and pay $250. If there is a 1/100 chance of winning the numbers then a player will, in expectation, win every two years or so...if they use these "winnings" to buy big ticket items like a car (or a suit in  your example) you can see how this might work, logically.  Could these agents do better counterfactually?  Sure...even with a passbook savings account they would expect at least twice as much money in the same time frame. 

So why might people do this? There are typically two arguments: 1) poor access to financial services...if you can't get a bank account, don't trust banks, or whatever, then you can see why you might put your faith in a system that has been in place all your life. 2) Self-control issues...if you need $250 for your big ticket items, but know that any time your bank account reaches $100  you will spend the money on something else, then you might opt-into a mechanism designed to short-circuit your lack of self-control.

I like your negative compounding story...it suggests that the optimal savings rate for "negative compounders" is less than zero.  This certainly speaks to issues like social security: If a large proportion of the population are negative compounders do mandatory retirement savings seem appropriate? (I realize that social security is pay-as-you-go)  How does this affect the positive compounders?  Can you think about health care in a similar way?

 

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#3) On July 28, 2008 at 12:49 PM, FleaBagger (28.84) wrote:

khrushchv - first, nice screen name. Second, irresponsibility is as much an effect of enabling gov't policies as it is a cause (or a need) of them. People would certainly take more responsibility for their lives if there were no money given for irresponsibility, and if there were no forced-participation retirement programs (especially rob from the young, who are mostly poor, and give to the old, who are mostly well-to-do and more organized as a lobby programs).

In any event, if we have freedom we respect each other more, rely on our neighbors more and on gov't less, and we prosper.

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#4) On July 28, 2008 at 2:50 PM, khrushchv (< 20) wrote:

FleaBagger: Thanks...my handle came out of the old IRC...although it used to have one less h, somewhere...

OK, so please don't misinterpret my post above as my personal opinion (which I will expound upon shortly).  I have been trained to think about incentives and institutions in a detached and analytical way.  I also have infinite respect for individual opinions as they are, in effect, individual rights...you are welcome to hold any opinion you want...it may or may not be based on facts or sound reasoning but you are perfectly welcome to it since, at the end of the day, you're the only person you have to sleep with...

I personally agree with you that responsibility rests at the level of the individual...perforce, individuals need to take responsibility for their actions...all of them...traditionally, the mechanism(s) in place to deal with irresponsibility were more grass-roots (e.g. families, neighborhoods, and churches).  It seems that more and more social issues are being dealth with at arms length. 

I also agree that irresponsibility intervention policies have the likelihood of creating a slippery slope toward more and more socialization.  We can discuss the high and low points of more or less socialized institutuions but I think it would be difficult to argue against the conclusion...it's just a matter of incentives.

As a "younger guy", I remain mad as hell that the generation preceding mine has been so fiscally irresponsible in so many dimensions. Why do we have such an enormous national debt?  What kind of demented thinking led us to pay-as-you-go social security?  Why are we effectively subsidizing foreign countries to sort out their domestic issues when we could focus on resolving our own?  Who benefits from these subsidies?  

Last, just because I'm mad at the results doesn't imply that I don't understand how we got here or why these outcomes could have arisen given the istitutions we have in place.

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#5) On July 28, 2008 at 5:37 PM, jesusfreakinco (29.04) wrote:

Seems MER is doing a different type of compounding after hours today - compounding shares upon shares, making all shares worth less...  Pretty soon they may be worthless...

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#6) On August 01, 2008 at 3:31 PM, TMFEldrehad (100.00) wrote:

I think negative compounding, for many, is even worse.

Most of us who've been around the Fool any length of time have read about how compounding interest works over time.  What all too many people don't seem to grasp, in my view, is that avoiding paying interest has the exact same financial impact as earning it.

How many people carry credit card balances at interest rates around 18% (or higher) month in, month out, year in, year out?  Frivilous spending of windfall money can certainly be costly to one's long-term financial position -- but frivilous spending with borrowed money compounds the problem many, many times over.

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#7) On August 05, 2008 at 2:11 AM, dwot (67.39) wrote:

Think about this...

The theory behind penions is compounding...  The money is supposed to be there compounding away and growing...

Now, consider governments that pay the social pensions...  Haven't governments been doing the negative compounding thing? 

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#8) On August 06, 2008 at 5:02 PM, ssecca (< 20) wrote:

About Bank of America, I have owned Bank of America through bank buy outs since 1986.In 1986 I bought 100 shares of a local bank stock. a few months later I bought another 100 shares. Then another 100 shares. Through out that time I reinvested the dividends, and continued to buy shares through a monthly plan. A couple of years later, another bank bought out that local bank, and I got a few more shares of stocks and a better dividend. A couple of years later another bank bought out that bank, and I got a few more shares, and a better dividend, Finally Bank of America bought out that bank and I got a few more shares and a better dividend. Throughout this period I kept reinvestinmg the dividends until a couple of years ago. When I retired I began  taking the dividends in cash. Through this period I gathered 2327 shares of Bank of America. My total investment has been $27,000. Since taking the dividends in cash, I have received about $17,000. Bnnk of America does not owe me anything.

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#9) On August 13, 2008 at 9:05 AM, bumseat (72.11) wrote:

Compounding and 401k's are the best deal for younger workers. It's a hedge for people of all ages. If you are fortunate, work hard and diversify you can be the next Buffett.

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#10) On August 25, 2008 at 4:57 PM, russiangambit (29.46) wrote:

Compounding only works when interest rates are higher when inflation. I high inflation countries (emerging markets) people put money in things and resell these things later (flats, cars, electronics and such).

The last 10 years have been horrible for savers in the US, 1% interest rates paid by the banks, inflation meawhile has been 1-2%. Sp500 is pretty much flat last 10 years. So, these 401K plans has gone nowhere last 10 years, compoundig or not.

 

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