Compound interest has a major wealth creation flaw

Published: 06th October 2011
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Compound interest was thought to be the 8th wonder in the world by Albert Einstein. However, when compounding starts to hurt you (i.e. negative compounding), it can virtually place you finances under severe strain.

Compounding is a principle that applies to all areas of life - not just investing and financing.

To give just one example, weight training rarely produces immediate physical changes, since it is meant to compound over the long term and significantly increases your muscle mass and overall health.

Now consider your business. Be sure to always give your customers the best service. Their positive word-of-mouth advertising will have a cumulative effect or compound as time passes, providing you with steady, reliable income.

Compounding can also hurt you:

1. What if, instead of weight training, you spent your time watching soap operas and eating junk food? You may not see any immediate harm, but eventually you would feel the effects of ill health, high cholesterol, and a poor physique.

2. If you provide service that is "hit-and-miss" in quality, your profits will decline, and you will eventually file for bankruptcy.

Compounding can positively or negatively affect many things, especially money. Financially speaking, compound interest is when your money generates more money or works for you.

This is dependent on one thing. Your business or investments must post yearly profits over the long term.

While a $1000 investment will grow to $6727 in 20 years at a rate of 10% interest, that will only happen if every year of that 20 nets you a 10% rate of interest. It is relatively easy to profit from positive compounding during economically prosperous periods.

However, what about poor economic times, when negative returns are possible? Does positive compounding still have a positive impact on you?

No; any investment that loses half its value needs to do twice the amount of work in order to return to its original worth. An investment that takes a 50% hit in its first year and a 20% one in its second year needs 150% growth in its third year just to reach its original starting value.

How things really are:

1. Negative compounding affects your bottom line in a negative way.

2. There are lots of negative price changes in the stock market. When you buy and hold stocks, your investments will be exposed to both positive and negative price changes.

3. Remember that experts in the financial field put the spotlight on their yearly returns so that their products can be shown at their best advantage. This can be very misleading. Salesman will praise positive compounding while avoid mentioning the possible negative effects.

Wealth generators mitigate negative compounding in three ways:

1. They actively manage investments and businesses. You can no longer passively let your money grow with a unit trust or mutual fund with any future guarantee of financial freedom.

2. Their strategies are intended to adjust to good and bad economies. To do this, one needs to have risk management techniques in place, and have the ability to read trends in the market. Since most professional fund managers cannot claim to have consistently done better than the market, this is not a job to be considered easy.

3. People who are very good at wealth building know how to turn people's needs to their advantage rather than playing numbers on the stock market. You must develop a passive income business model that generates streams of passive income that are based on the basic needs of your customers.

The real lesson here is that the basic needs of humanity are easier to predict than the stock market movements or trends in the economy. It is better to build wealth by basing your product and services on distinct human needs.

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