What they don’t tell you about ETFs and their profitability
Compound interest is often presented as the magic formula for financial growth, but before getting swept up in promises of quick wealth, it's crucial to understand what it really entails and, more importantly, what you're not being told.
The first documented reference to compound interest appeared in an advertisement for The Equity Savings and Loan Company back in 1925. Since then, the financial industry has capitalized on this concept, not just for its potential, but also because many investors get convinced by the magic of compound interest, depositing their savings without considering other crucial factors.
Simple vs. Compound Interest: What are we talking about?
It's essential to understand the difference between simple interest and compound interest. Simple interest follows a linear progression, while compound interest grows exponentially. In the long term, those using compound interest can benefit greatly, but knowing its power doesn’t mean we should blindly invest in any financial product that promotes it.
Basic example: How much more can you earn?
If you invest $10,000 at 10% for 10 years with simple interest, you'll earn $1,000 per year. Your final position would be worth $20,000. With compound interest, reinvesting the interest each year, the final value rises to $25,937.42. The difference is clear: compound interest can work wonders when handled correctly. But it’s not as simple as it seems.
What the financial industry doesn’t tell you
The sequence of returns: Not everything is predictable
One of the biggest risks in investing is the sequence of returns. The market doesn’t provide a constant return year after year. It might go up by 10% one year and drop by another 10% the next. This means you can go through long periods without seeing real growth in your assets, even if you keep contributing capital. This volatility is something every investor needs to be prepared to accept.
Inflation: The constant enemy
Inflation is another factor that affects the results of compound interest. The money you accumulate today won’t have the same value in 10 years. Assuming an annual inflation rate of 2%, your real return will be reduced. Therefore, it’s crucial to adjust your expectations and always consider this effect.
Taxes: The inevitable cut
In Spain, capital gains taxes range from 19% to 23%. This means if you manage to generate $211,000 in profits, you’ll have to pay around $48,000 in taxes, significantly reducing your net gain. So when calculating your returns, don’t forget that the taxman will always be waiting for their share.
Currency risk: Not everything depends on the market
If you invest in assets denominated in a foreign currency, you’ll be exposed to exchange rate fluctuations. While there are options to hedge this exposure, these hedges come at a cost that will impact your returns. It’s something to keep in mind, especially if you’re planning to invest long-term in international markets.
Fees: Everything has a price
We can’t forget the costs associated with investment vehicles like ETFs or index funds. Even though their fees are typically low, over time they affect the final return. So it’s important to consider them when making a realistic projection of your profits.
Opportunity cost
It’s not healthy to obsess over making the perfect investment. That’s not realistic. However, it is crucial to aim for selecting a good ETF, as, for example, if we had bought the IBEX35 over the past few decades, we would have had a return far below that of the S&P500.
A poor selection of an instrument can severely impact your wealth, so it’s important to learn how to actively manage your investments, even if it’s just a quarterly or semi-annual review of your portfolio.
Conclusion: Compound interest, without the sugar-coating
Compound interest is, without a doubt, a powerful tool. However, its effectiveness depends on multiple factors: market volatility, inflation, taxes, currency fluctuations, and investment costs. It’s not a smooth or obstacle-free path, but with a solid strategy and a clear understanding of the risks, it can work in your favour.
In our post on how to start investing, we discussed the advantages of active management as well as its risks.
The most attractive ETFs right now
At Breaking Bucks, we believe some U.S. indices like the S&P500 or NASDAQ are currently less attractive, as they’ve recently hit all-time highs and their average company valuations are well above historical norms.
Additionally, a weakening dollar due to falling interest rates and a gradual reduction in demand makes it less appealing.
Other indices like Shanghai, Shenzhen, or Hong Kong are hovering near their 2011 lows. Although they’ve recently started to recover, these indices remain undervalued, and a cheap yuan offers an extra incentive.
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