Albert Einstein is my idol, his scientific mindsets could be applied in investing world (inspiring me to establish Ein55 Styles of investing). He said “Compound Interest is the 8th Wonder of the World”. It is important for an investor to know which role to play, receiving or paying the compound interest. The results can be very different.
1) Receiving Compound Interest
Growth stocks receive compound interest with growing business and share price. An investor could become richer at faster rate because the growth stock may not pay dividend. Instead, the earning is invested back to the business to enlarge the market share, revenue and income. Even after a business has reached its maturity, the excess income could be redistributed as dividend to shareholders who could invest in other growth companies.
2) Paying Compound Interest
Junk stocks pay compounding interest with declining business and share price. An investor could become poorer at faster rate because the company business could be in crisis, not making money but still need to pay high interest of debt yearly. The worst is the company may still pay dividend to the shareholders with past saving while the company is still losing money, need to borrow more money externally at highest interest rate. This is a process of burning money. Eventually, the company could go bankrupt and the investors could lose all the money invested in a short time.
Compounding interest is a double-edged sword, if we use it correctly, the business could grow faster, an investor could benefit from larger capital gains and passive incomes from dividends. If this weapon is generalized, it is not limited to “interest” literally, it could be any method which could give the special edge to an investor or trader, eg:
1) Optimism Strategy – Reward/Risk ratio
2) Fundamental Analysis (FA) – Business Strength
3) Technical Analysis (TA) – Momentum / Trend Following
4) Personal Analysis (PA) – Contrarian to Herd Mentality
Ideally, we could integrate all the 4 weapons of (Optimism = FA + TA + PA), into a mega compound “interest” to accelerate the growth in investment.