The Best Thoughts On Compound Interest – “Rich Man, Poor Man”

russellSeveral years ago, I found Richard Russell’s essay titled, “Rich Man, Poor Man.” Richard wrote the Dow Theory Letters for decades and truly understands the power of compound interest. This essay was the most popular he’d written in over 40 years. In this post, we’ll walk through a few of his ideas. I hope this has the same impact on you as it did on me.

Text in italics is from Russell’s essay.

“Making money entails a lot more than predicting which way the stock or bond markets are heading or trying to figure which stock or fund will double over the next few years. For the great majority of investors, making money requires a plan, self-discipline and desire. I say, “for the great majority of people” because if you’re a Steven Spielberg or a Bill Gates you don’t have to know about the Dow or the markets or about yields or price/earnings ratios. You’re a phenomenon in your own field, and you’re going to make big money as a by-product of your talent and ability. But this kind of genius is rare. For the average investor, you and me, we’re not geniuses so we have to have a financial plan. In view of this, I offer below a few items that we must be aware of if we are serious about making money.”

I’m an average investor. I have proven to myself over and over again that I do not have the ability to predict any of the financial markets. Right now, I tend to think the bond market is in a large bubble and that it will crash when interest rates increase. The problem is I don’t know when, or if, interest rates will increase. I can make investments today that will increase in value when interest rates rise, but these investments would really be just a gamble. There are so many factors entwined together that I have no clue what will happen in any market going forward.

To be successful as an investors, we have to make a financial plan designed to succeed regardless of what happens in the financial markets. According to Russell, this investment plan should be around compound interest. He explains why in his four rules:

Rule 1: Compounding: One of the most important lessons for living in the modern world is that to survive you’ve got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation — and money. When I taught my kids about money, the first thing I taught them was the use of the “money bible.” What’s the money bible? Simple, it’s a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following:perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious — compounding may involve sacrifice (you can’t spend it and still save it). Second, compounding is boring — b-o-r-i-n-g. Or I should say it’s boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!

Russell continues the essay showing the charts comparing two investors. One who invests $2,000 a year starting at the age of 19 for seven years with another who starts investing $2,000 a year, each and every year, starting the age of 26. The first investor only invests $14,000 and ends up with $930,000 at the age of 65, while the second investor invests a total of $80,000 and for a total of $893,704 at the age of 65. You’ve seen these charts and they’re powerful.

Rule 2: DON’T LOSE MONEY: This may sound naive, but believe me it isn’t. If you want to be wealthy, you must not lose money, or I should say must not lose BIG money. Absurd rule, silly rule? Maybe, but MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten business deals, greed, poor timing. Yes, after almost five decades of investing and talking to investors, I can tell you that most people definitely DO lose money, lose big time — in the stock market, in options and futures, in real estate, in bad loans, in mindless gambling, and in their own business.

I broke Russell’s Rule 2 and lost a lot of money. I learned many valuable lessons. The most important of which (at least for me) is not to focus on appreciation. Appreciation is similar to fools gold. Our investments appreciate and we think we’ve hit the jackpot. Then our investments depreciate and we think the world has ended. We have no control over the appreciation of our assets. We also have no control over the market value of our investments. Because of this lack of control, it’s crazy to make appreciation the central focus of our investment plan.

When we focus on compound interest, we have 100% control and can be extremely successful over time.

RULE 3: RICH MAN, POOR MAN: In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN’T NEED THE MARKETS. I can’t begin to tell you what a difference that makes, both in one’s mental attitude and in the way one actually handles one’s money.

The wealthy investor doesn’t need the markets, because he already has all the income he needs. He has money coming in via bonds, T-bills, money market funds, stocks and real estate. In other words, the wealthy investor never feels pressured to “make money” in the market.

The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the “give away” table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

And if no outstanding values are available, the wealthy investors waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn’t mind waiting months or even years for his next investment (they call that patience).

But what about the little guy? This fellow always feels pressured to “make money.” And in return he’s always pressuring the market to “do something” for him. But sadly, the market isn’t interested. When the little guy isn’t buying stocks offering 1% or 2% yields, he’s off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he’s spending 20 bucks a week on lottery tickets, or he’s “investing” in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).

And because the little guy is trying to force the market to do something for him, he’s a guaranteed loser. The little guy doesn’t understand values so he constantly overpays. He doesn’t comprehend the power of compounding, and he doesn’t understand money. He’s never heard the adage, “He who understands interest — earns it. He who doesn’t understand interest — pays it.”The little guy is the typical American, and he’s deeply in debt.

The little guy is in hock up to his ears. As a result, he’s always sweating — sweating to make payments on his house, his refrigerator, his car or his lawn mower. He’s impatient, and he feels perpetually put upon. He tells himself that he has to make money — fast. And he dreams of those “big, juicy mega-bucks.” In the end, the little guy wastes his money in the market, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, this “money-nerd” spends his life dashing up the financial down-escalator.

But here’s the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he’d have money coming in daily, weekly, monthly, just like the rich man. The little guy would have become a financial winner, instead of a pathetic loser.

Read Rule #3 one more time.

It might be one of the most important thoughts on investing ever written. By focusing our investments around compound interest, our investment income increases with each passing year. We don’t have to worry about the market crashing. In fact, a market crash becomes a lucrative opportunity, because we can use the investment income to buy assets at depressed prices. If we see a great investment, we can buy it. If we don’t see any great investments, we can just kick back and relax allowing the investment income to pile up. Sooner or later, an incredible investment opportunity will arrive and we’ll be ready to take advantage of it.

RULE 4: VALUES: The only time the average investor should stray outside the basic compounding system is when a given market offers outstanding value. I judge an investment to be a great value when it offers (a) safety; (b) an attractive return; and (c) a good chance of appreciating in price. At all other times, the compounding route is safer and probably a lot more profitable, at least in the long run.

I try and review Russell’s essay several times a year. It helps me to stay focused and it also helps to eliminate distractions. “The only time the average investor (me) should stray outside the basic compounding system is when a given market offers outstanding value.” If there are no outstanding values, than we must continue compounding investment income.

To me, this means we shouldn’t buy ANY investment that doesn’t produce income UNLESS it is a great value. Think about your investments. Do you own any investments that don’t provide income? If so, these investments must be great values, or you’re violating Russell’s rules.

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