I want to talk to you about two types of investing and how to measure their performance. The first one is variable investing, which is anything that can go up and down in value. Mistakenly that often gets measured in terms of average rates of return. And then there is compound interest and it just builds interest every year. Let’s look at the difference between these two and their potential.

Albert Einstein was accredited with saying that compound interest was the most powerful force in the universe.

So how does compound interest work? You have three things that are going on with compounding interest. The first is your principal, the second is your rate of interest, and the third is the interest that you earn on the saved interest each year. It’s compounded interest because you’re folding the interest or compounding it back into the principal amount. So each year, not only does your principal grow, but so does your interest.

Rule of 72 and Compound Interest

The Rule of 72 is a key formula. You should not even be investing or talking about average rates of return until you fully understand the Rule of 72. You are going to see how every time compounding interest beats the performance of the stock market over the long run.

With the rule of 72, you take any interest rate, and divide it into the number 72. The answer shows you how many years it will take to double your money.

Let’s take a 6% rate of return, we divide that into 72 and that tells us how many years it will take to double your money at 6%. In this case the answer is 12.

We have someone, 29 years old, they’ve inherited $20,000 from Grandma, and they are going to earn 6% on it every year.

Age 29: $20,000

Age 41: $40,000

Age 53: $80,000

Age 65: $160,000

Good? Bad? Well, it’s all relative, but the point is if you know the Rule of 72 you would know exactly at age 29 what your money is going to look like at 65.

Now let’s take a 12% rate of return and see what that looks like if we divide that into 72, and how many years to double our money at 12%. It’s 6 years. Here’s the same scenario.

Age 29: $20,000

Age 35: $40,000

Age 41: $80,000

Age 47: $160,000

Age 53: $320,000

Age 59: $640,000

Age 65: $1,280,000

At age 65 you’ve got $1,280,000 from the base amount of $20,000! That’s eight times more than at 6%. If you double your interest rate, you don’t just double your net. Your net after 36 years is eight times more. Compounded interest can make a huge difference in your outcomes.

Average Rates of Return

Now that you understand how interest is compounded, I want to compare this to average rates of return. Whether it’s correct or not, quite commonly average rates of return are used in promoting and evaluating stock and mutual fund performance.

How to do an average? Take these annual returns:

year 1: plus 10%;

year 2: plus 11%;

year 3: minus 10%;

year 4: minus 7%;

year 5: plus 16%.

Add these up, you get 20.

Take 20, divide by 5 years, and we have a 4% average rate of return. And the numbers above are not representative of specific years for the stock market.

Now let’s look at this average rate of returns in use.

If you had an initial investment of $1,000 with an average rate of return of 20% per year, how much would you have at the end of two years? $1,440? $1,280? $800? Or $0? Think about that for a minute and figure out your answer.

You had $1,000 and it earns 20%. At the end of the year you had $1,200, right? So then you take your $1,200 and you get 20% on that, and you’ve got $1,440. That’s probably what you were thinking.

Now let’s take another look.

Example 1:

Starting investment: $1,000

year 1: +60% = $1,600

year 2: -20% = $1,280

That’s plus 60%; minus 20%; 40 divided by two years, and that’s also a 20% average rate of return per year but we didn’t get the same answer. We got $1,280!

Example 2:

Starting investment: $1,000

year 1: +100% = $2,000

year 2: -60% = $800

Plus 100% and minus 60% equals 40 and if you divide that by two years you still have a 20% average rate of return per year. You make 20% average per year but you lost money!

Let’s go to the real estate market in Florida back in 2006 and 2007.

Example 3:

Starting investment: $1,000

year 1: +140% = $2,400

year 2: -100% = $0

Plus 140% and minus 100% still equals 40, divide by two years and it’s a 20% average rate of return, but you just happen to have zero dollars to show for it!

All these answers are all correct and that’s the actual problem!

Example 4:

Starting investment: $100,000

year 1: -50% = $50,000

year 2: +100% = $100,000

Negative 50% plus 100% equals 50%, and if you divide that by two years that’s a 25% average rate per year, yet you haven’t made any money.

Average Rate of Return Vs. Compound Interest

Let’s talk about the S&P 500 because it’s an index that’s quite diversified. It represents a robust picture of the whole economy.

S&P 500:

March 2009: 683

February 2011: 1319

That’s a 93% increase in your worth in the stock market or about 48% per year across that time. Now who wouldn’t want to get that?

You have often heard that the stock market is your best long term investment. But look at what's happened since March of 2009 and put it into the bigger picture of 11 years of performance in the S&P 500.

All that’s really happened with this record breaking growth since 2009, is we have barely gotten back to where the market was 11 years ago. Over all of these years the market has had an "average rate of return" of 3.01%.

If you add up from 2000 to 2011 all the growth and contraction numbers, we get 33.06, we divide 33.06 by 11 years and we wind up with 3.01%, which is the average rate of return. Yet the S&P in 2000 was 1366 and in 2011 it’s at 1319.

With an average rate of return of 3.01% and investing $100,000, you should have $138,571 at this point after 11 years of that compounding growth. But your actual dollar return on $100,000 in this index over this 11 year period is not up, its down, to $96,594 after 11 years in the market.

The actual rate of return is negative 0.32% per year.

You’ve lost money but you got an average rate of return of 3.01% per year and the moral of the story is average rates of return in any thing that could decrease in value are a lie, they are a worthless statistic!

Where are we going for the future of the Baby Boom generation? We have had this terrible recession and the Federal Reserve Bank printed a whole lot of new dollars we probably borrowed from China; and the result is... Well, real estate prices are still down, gas is going through the roof, the national debt is out of control and we have political strife all over the world, and we’ve got natural disasters. And all these things roil the stock market!

With this much volatility, where are we going to find ourselves the day we need to retire?

In the midst of the calamity that could be the stock market in the next decade, what could it mean to guarantee 7.2% compounded interest each year?

Per the Rule of 72, if I take that 7.2% and I divide it into the number 72, I now know that every 10 years I am going to double my money. Now this is the minimum guarantee for many retirement planning products. This is the worst that they do!

Well if I take the S&P and if it were to actually gain 7.2% in the next ten years, the S&P would have to go from 1,300 to 2,600, and that’s completely not characteristic of the S&P. And yet keep in mind that this isn't IF the market can give it, this is the minimum guaranteed value we are doing on many of our retirement products. You might do better!

So if that’s the case what would happen in 20 years? The S&P would have to be at 2,600 in 10 years, and at 5,200 in 20 years to get to exactly where we can guarantee your asset growth, simply by putting 7.2% per year compounded growth together year after year. 7.2% should be starting to look a little more interesting than maybe be you first thought!

Now the logical question is, How can they do that? How does that all work? How do you go and get 7.2% when no one is offering that kind of guarantee?

Well you know what? It’s not really rocket science and when we show you how it’s done you are probably going to slap your head. It’s simpler than you think.