When it comes to managing your money, time can be a blessing or a nightmare. Consider the following two examples of long-term investing and outstanding consumer debt. Compound interest can work for you or against you.
What matters most in investing is not timing, but time. Historical evidence indicates that there has been no better way to reduce the risk of losing money, and enhance potential returns, than through long-term investing. Time diversification is the reduction in risk that accompanies the lengthening of an investor's time horizon.
Historical investment data compiled by the investment research firm, Ibbotson Associates, indicate that time decreases the amount of volatility, or ups and downs in prices, of investments. In other words, the highs aren't as high, and the lows aren't as low, as an investor's time horizon increases. As you extend the time frame, the extreme ups and downs flatten out dramatically. By the time you've invested 15 or 20 years, there is a relatively narrow range of returns.
Time diversification reduces the risk of buying or selling investments at a bad time in the economic cycle. It has a much greater impact on investments, like stock, with a high degree of volatility than on relatively stable investments such as short-term bonds and money market funds. The stock market is notoriously risky over one-year periods and, unfortunately, many investors panic and sell at a loss during market downturns.
Thanks to time diversification, however, patient investors are generally rewarded with good long-term performance. Spans of three years or more provide investors with a much greater chance of success. Since 1926, the Standard & Poor's 500 (stock market index) has declined in just 41 of all 293 rolling three-year time periods (1926-28, 1927-29, etc.).
Unfortunately, some investors are market timers, who shift money around and overreact to market conditions. By doing so, they squander the benefits of time diversification. The longer an investment is held, the better. A time horizon of 10+ years generally includes several economic cycles and provides good time diversification. Missing just a few if the best trading days with the greatest gains can drastically affect investment performance.
Compound interest can also be your enemy. An example of the latter is someone who owes $10,000 on a credit card with a 17% annual percentage rate (APR) and a minimum payment of 2% of the outstanding balance. Assuming that only minimum payments are made, it will take 50 years to repay this debt and the total repayment would be $33,447: the original $10,000, plus $23,447 in interest, according to the book Slash Your Debt.
Like home mortgages, debt that takes decades to repay will cost 2 to 3 times the amount borrowed. Many people have no idea how much they pay out in interest because they pay in small increments over long periods of time. Also, the outstanding balance is constantly changing every time a new purchase is made.
The best way out of debt is to put time on your side by shortening the time it takes to repay it. This can be accomplished by negotiating a reduced interest rate with creditors (so more principal is repaid with each payment) and/or paying more than the minimum due. Even small amounts added to minimum payments produce awesome results. For example, send $25 a month more on a 17%, $10,000 credit card balance and you'll save $11,662 in interest and 397 monthly payments, according to Slash Your Debt. An extra $50 per month will save $15,211 and 468 payments and even 25 cents extra a day will save $5,970 and 20 years of payments.