Recently, I got a great question about compound interest. Everyone is taught the power of compounding… Usually the story goes something like "If you invested $1,000 in 1900 at 5% compound interest, it would be worth $236,000 today!".
If 100 years works that well, why not leave the money to compound for 300 years? Then your heirs would have $2.3 billion! Why doesn't everyone do this? Because while this may be mathematically true, in the real world, it is riddled with problems.
Let's look at some examples. What is the value of 1000 Dollars placed on deposit at 5% in 1863 and left to compound for 150 years? If you lived in Atlanta, Georgia, and they were Dollars issued by the Confederate States of America, are they now worth $1.5 million as the math would predict? Or something closer to, oh, I don't know, maybe ZERO? The same goes for the value of 1000 Zimbabwe Dollars put on deposit at 5% in 1970 and left to compound for 43 years. Even with a world-beating return of 25% per year, compounded for 43 years, or 150 years, you would still be dead broke.
There are so many risks in such an investment… including the bank or institution holding your money. They could go out of business – think MF Global. They could be crooks. Think Bernie Madoff. Even if your deposits are insured, the insurance issuer could go bust. And even if you dodge these bullets, the money itself could become worthless, as in the examples above.
But enough ragging on currency failures of the past. What about the good old US Dollar? To make a concrete real-world case, I took the 1 year treasury bill rates from the Federal Reserve website, and calculated the compound growth of buying t-bills at a discount each year, and reinvesting the proceeds each time they matured. I started in July 1959 because that's where the Fed's dataset starts. I chose 1 kg of gold (worth $1,128.49 in 1959) as the initial investment, and plotted the gold value of the investment each year, up to July of 2012. Here is the chart:
Over this 52 year period, interest rates varied from 14.25% in 1982 to 0.2% in 2012. The initial $1,128 invested grew to $21,129 in 2012. But those $21,129 dollars could only buy 405 grams of gold in 2012, 59% less than the initial investment.
Over the 52 year period, the investment was in the black about 40% the time, and underwater the other 60%. At this point, currency debasement is totally overwhelming the compounding effect.
Never forget that US Dollars (like all other government currencies) are irredeemable. That means that although you can trade USD for many goods and services – even gold – in the market today, no bank or government agency is required to redeem your dollars for anything. At some point, market confidence in the dollar will fade, and the bid for dollars will shrink. And shrink some more. And then the bid for dollars will be withdrawn. That's Zimbabwe Time! To learn more about the details of this process, I recommend visiting Keith Weiner's Monetary Metals website. Keith has put together some excellent videos on this topic.
When the music stops, you don't want to be stuck holding the Old Maid. Be sure you have some physical gold in your posession. And for pete's sake, measure your investment results in gold, not dollars!