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Exercising compounding discipline

Discussion in 'General Discussion | Finance' started by Free-quent Flyer, Sep 29, 2015.

  1. I've written both here and on my blog about ways that it's possible to use manufactured spending techniques and high-interest weirdo prepaid and rewards checking accounts to replicate and replace traditional elements of an investment portfolio.

    For example: https://saverocity.com/forum/thread...s-taking-into-account-other-positions.132242/
    and http://freequentflyerbook.com/blog/2014/7/8/us-banks-quietly-great-credit-card

    One thing I've been giving some thought to lately is how to ensure that you're taking advantage of the advantages of compound interest when you use these techniques.

    Take a fund like VFIFX, which currently has an asset allocation of:

    Domestic equity: 54.2%
    International equity: 35.8%
    Domestic fixed income: 7%
    International fixed income 3%.

    If you want to replicate that allocation using a 5% APY rewards checking account with a $20,000 maximum high-interest balance, you can cut out the domestic and international fixed income until your total portfolio is $200,000 (with the remaining $180,000 split 60.2% domestic equity/39.8% international equity).

    However, a problem arises when you have your high-interest account maxed out, because you're earning approximately $1,000 in annual interest on that $20,000 balance, which earns next to nothing if it remains in the high-interest account.

    If you always contribute $5,500 to your IRA accounts, you might decide to simply "replace" $1,000 of that with the interest earned on your $20,000 balance. The net effect of that, however, would be to reduce your annual retirement savings from $5,500 to $4,500, since your high-interest account is supposed to be replicating funds that would otherwise be earning interest in your retirement account!

    That gives rise to what I call "compounding discipline." It's the necessity to exercise discipline and dedicate your returns from "alternative" investments to either the same or to a different vehicle, in order to generate compounded returns over the medium-to-long term.

    I know @Matt is sick of hearing about high-interest accounts, so let's take a totally unrelated example: Kiva loans.

    If you have a US Bank Cash+ card, you can earn 5% cash back on up to $2,000 per calendar quarter in Kiva loans (when you select "Charity" as one of your 5% bonus categories). If you do so each quarter, you can earn 5% on $8,000 in Kiva loans (ignoring for simplicity's sake the fact that Kiva loans can have less than 12-month terms, which can raise your annualized returns by freeing up your money sooner), minus any defaults and delinquencies. The cash back is also tax free, which is nice.

    But if you take that $400 in annual cash back and spend it, you miss out on the advantages of compound interest. Likewise, if you use it to "replace" contributions you were already making to a retirement savings account, you're simply reducing your retirement savings by an identical amount (see above).

    The solution, again, is to exercise compounding discipline and direct the $400 towards new, hopefully equally lucrative investment opportunities.
     
  2. Matt

    Matt Administrator Staff Member

    Tangentially i've been thinking about this for travel hacking rather than finance recently... for the finance side, its that constant challenge of when can you ever spend money, since spending it means you aren't compounding anymore... I touched on it recently in a post about Rich Dad Poor Dad, why would his approach be that you could only buy a fancy car if you did so with the proceeds of investment, rather than reinvest them?

    I guess at some point you have to just spend... perhaps there are thresholds to explore, such as when your compounding and passive (ish) income gigs are sustaining your lifestyle?
     

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