Once upon a time in the United States, regular savings accounts paid over 5% interest. The May 31, 1979, issue of the New York Times reported that federal regulators allowed commercial banks to pay 5.25% interest on their savings accounts, while savings and loans and mutual savings banks were able to pay as high as 5.5%.
The reason for such a “high” rate of return was the inflation rate in 1979 – 11.35%. Inflation was an issue throughout the 1970s – does anyone remember President Gerald Ford’s 1974 program called “Whip Inflation Now” or “WIN”? The program had little effectiveness. Inflation did drop in the later 70s but exploded at the end of the decade. It reached its peak in April 1980 at 14.76%. In comparison, the current U.S. inflation rate as of April 2022 is 8.3%.
To secure more deposits when they were able to pay higher interest on their accounts, bank and savings and loan marketing programs in the late 1970s and early 1980s touted the importance of compound interest. Compound interest is earning interest on the interest you’ve already earned. Some famous quotes about compound interest have been attributed to Benjamin Franklin and Albert Einstein. Whether they really said these things or not are a matter of debate, but the statements are still quite informative:
Benjamin Franklin: “Money makes money. And the money that money makes, makes money.”
Albert Einstein: “Compound interest is the eighth wonder of the world. He, who understands it, earns it; he who doesn't, pays it.” (Albert Einstein died in 1955. The first reference of this quote is found in a New York Times blurb from 1983).
Investor.gov, from the U.S. Securities and Exchange Commission (SEC), describes compound interest in this way:
Compound interest is the interest you earn on interest. This can be illustrated by using basic math: if you have $100 and it earns 5% interest each year, you'll have $105 at the end of the first year. At the end of the second year, you'll have $110.25. Not only did you earn $5 on the initial $100 deposit, you also earned $0.25 on the $5 in interest. While 25 cents may not sound like much at first, it adds up over time. Even if you never add another dime to that account, in 10 years you'll have more than $162 thanks to the power of compound interest, and in 25 years you'll have almost $340.
Dividend Reinvestment Is the Ninth Wonder of the World
If compound interest is the eighth wonder of the world, compound dividends — especially the dividends of real estate investment trusts (REITs) when they are reinvested into more shares — is the ninth wonder of the world.
Banks no longer offer 5.5% regular savings accounts like they did in 1979. It’s extremely difficult today to accumulate substantial interest earnings from fixed-income accounts. The highest-paying savings account on June 9, 2022, pays only 1.25% interest.
Such a low interest rate — even when it’s compounded — offers little for those who depend on fixed income assets, such as retirees. On top of that, when there’s an annual inflation rate like today of 8.3%, folks who live off fixed income instruments fall behind on a daily basis. In a very real and personal way, they realize their continuous drop of buying power whenever they put gas in their vehicles or shop at a grocery store.
REITs offer the potential of increasing principal. REITs often increase in share price, even more so than the general stock market. The National Association of Real Estate Investment Trusts (Nareit) measures daily the performance of equity REITs. For the 20-year period ending in December 2019, the FTSE Nareit All Equity REITs Index measured that REITs outperformed the Russell 1000 11.6% vs. 6.29%.
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Comparing Compound Interest vs. Compound Dividends
Let’s compare interest from fixed-rate savings accounts with potential returns in REITs. An important difference between these savings accounts and REITs lies in their risk level. Although REITs are generally considered less risky than stocks, they still carry risk. For example, when you deposit $10,000 in a savings account — called the “principal” — you know you will get your principal back. With a REIT, the return of principal is not guaranteed. When you buy into a REIT, you are investing; when you deposit money in a bank account it is categorized as saving.
In this example, the first investor places money in a savings account that pays 4% interest — this rate is used only for an example because you wouldn’t be able to find a savings account today paying that interest rate. Because of compound interest, the amount of the savings account increases every year, although the interest rate stays the same at 4%.
After a period of 30 years, this savings account increases over three times in value. If the investor is able to maintain the savings account for 50 years, it will grow in value over seven times more than what was originally deposited.
The second investor uses the money to purchase several shares of a REIT, using an online brokerage account. The dividends are reinvested into more shares of the REIT. Let’s assume this REIT pays a 4% dividend (which is the same as the interest rate the first investor earned in a savings account). The major difference comes from the potential of the share price of the REIT to increase 3% every year, which is not unreasonable for a REIT, although that growth is not guaranteed.
After 30 years, the second investor’s REIT shares in this example would have increased more than 7.5 times more than the original deposit. If the investor can maintain the shares of the REIT in the brokerage account for 50 years, the value has the potential to grow more than 30 times the initial deposit.
If your personal risk tolerance and financial position allow it, what choice would you make, especially in an inflationary environment?
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