When studying investment basics, I’m reminded of a quote from none other than Albert Einstein who called compounding “the greatest mathematical discovery of all time”.
Stated differently, a dollar received today is worth more than a dollar received tomorrow. This simple but powerful sentence sums up the concept of the time value of money (TVM). It is true because of the earning capacity of money when it is invested and then re-invested. In my books and videos I listed the reasons why I sell options. One of those motives states “You can compound your profits in a matter of minutes”. This means that when the cash is immediately generated into our accounts from the sale of the call options, we can turn around and invest these profits. The sooner we put this money to work, the wealthier we become.
Future Value and Compounding:
Future value projects what an investment will be worth at some point in the future. For example, if we invested $10,000 for 5 years with a simple annual interest rate of 5%, a $500 per year profit would be gained each year for a total profit of $2,500. The future value of the investment is $12,500. Had we re-invested the $500 profit each year, thereby compounding our money, the resulting future value would be $12,762.82. Now let’s expand our time frame to 30 years. With simple interest our future value comes to $25,000 ($10,000 + $500 per year for 30 years). By using the power of compounding and re-investing each $500 interest payment the future value balloons to $43,219.42. As compounding periods increase, so do our bottom lines.
Internal Rate of Return (IRR):
IRR is a way to analyze an investment considering the time value of money. It basically calculates the interest rate which is the equivalent of the dollar amount your investment will return. Once you know the rate, you can compare it to IRR rates on other investment opportunities, or compare it to the actual cost of borrowing money for your investment. For example, if you borrow money and pay annual interest of 6%, your investment should show an IRR a lot higher than 6%. If we were able to increase our IRR from 5% to 6% in the above example, our future value would grow from $43,219.42 to $57,434.91. A 2% increase to 7% would result in a future value of $76,122.55. Never underestimate the power of compounding. This is why I immediately re-invest my call premiums whenever possible and my strategy philosophy is to reinvest premium profits rather than to use them to reduce my cost basis.
Compounding and the Rule of 72
This is a rule stating that in order to find the number of years required to double your money at a specific interest rate, you divide the annual compound return into 72. The result is the approximate number of years that it will take your investment to double. You can also calculate the interest rate required to double your money in a given amount of time. Here is a chart showing both calculations:
|Growth Rate||Time Required to Double||Calculation|
|4%||72/4 = 18|
|6%||72/6 = 12|
|8%||72/8 = 9|
|9%||72/9 = 8|
|10%||72/10 = 7.2 (years)|
|18||72/18 = 4|
|12||72/12 = 6|
|9||72/9 = 8|
|8||72/8 = 9|
|7.2||72/7.2 = 10|
Compounding your money
If we could achieve a conservative 2% per month return in normal market conditions, our annual rate of return would be 24%. That means our time to double our investment would be 3 years (72/24). An investment of $100k could grow to $1.6M in a 12 year time frame. That demonstrates how powerful compounding can be for our financial futures.
Covered Calls vs. Treasury Notes:
Let’s first state the obvious. We are comparing a low-risk investment to a no-risk investment. For undertaking that risk, we will be well paid in most market conditions. I want to focus on the compounding advantages of covered call writing compared to other investment vehicles. When we purchase a treasury note or bond @ par ($1000), we are guaranteed a specific interest rate or coupon. Let’s say that rate is 5% (wishful thinking!). Each year we will receive $50 in interest paid in two payments of $25 starting in 6 months and then a second installment six months later. When we sell a covered call option, that premium is instantly generated into our accounts and available to re-invest that same day or the next. If the cash is not needed, it behooves us to re-invest that income and start the geometric progression compounding offers us as a path to great wealth.
Each investment strategy has its unique advantages and disadvantages. Covered Call Writing allows us to generate initial profits instantaneously. It makes no sense to let this cash simply sit in our accounts. If we pull the money out and head to the local mall, we have created an opportunity lost. The earlier that money goes to work for us, the sooner we will no longer need to go to work ourselves. That is the power of compounding…the eight wonder of the world. Can’t argue with Albert Einstein!
The BCI team is in Las Vegas:
BCI team members and I will be in Las Vegas from the 13th through the 16th as an invited speaker at the Forex and Options Trading Expo @ the Paris Hotel. Every effort will be made to publish our weekly stock report as early in the weekend as possible although it may be published a bit later than usual. We will catch up on all on and off site comments and inquiries next week. All books and DVDs ordered over the weekend will be shipped on Monday.
On Thursday Fed Chairman Ben Bernanke announced a third round of quantitative easing (QE3) to encourage borrowing by buying $40 billion in mortgage-backed securities starting on Friday. He also announced that target short-term interest rates will remain near zero through mid-2015 while stating that monetary policy “cannot cure all economic ills” Other ecominc reports included:
- First time unemployment claims came in higher than expected
- CPI rose 0.6% in August
- Core CPI (excluding food and energy), however, rose only 0.1%
For the week, the S&P 500 rose by 1.9% for a year-to-date return of 18.4%, including dividends.
IBD: Confirmed uptrend
BCI: Moderately bullish favoring out-of-the-money strikes.
My best to all,
Alan ([email protected])