This article is an excerpt from the Shortform book guide to "Unscripted" by MJ DeMarco. Shortform has the world's best summaries and analyses of books you should be reading.
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Can you get rich off compound interest? Why is relying on compound interest a bad wealth-building strategy?
According to entrepreneur and investor MJ DeMarco, earning compound interest alone won’t get you rich. Instead of relying on compound interest to generate wealth, use it as a supplement to your profits.
Here’s why you shouldn’t rely on compound interest as your only way to acquire wealth.
Can You Get Rich off Compound Interest?
The idea that you can get rich off compound interest implies that you can create massive wealth by funneling small amounts of money toward pension and investment accounts. DeMarco argues that, because it encourages you to depend on unpredictable market forces to generate wealth for you, this belief convinces you to risk the money you do have.
In theory, investments create wealth by providing a predictable and healthy rate of return over the course of decades. In reality, however, the markets are unpredictable and the rates are too low to make a significant impact on the small, capped sums of money the government allows you to contribute to your investment accounts. You also can’t guarantee that financial managers won’t make poor decisions that lose you money or that the rate of inflation won’t reduce the value of your investments.
(Shortform note: David Bach (The Automatic Millionaire) offers a contrasting perspective on compound interest. He first explains that you’ll earn far more from investing small amounts of money than from not investing at all—the impact isn’t insignificant, as DeMarco suggests. Then, Bach suggests that diversifying your investments (by putting money into a combination of cash, bonds, and stocks) ensures the overall health of your investment portfolio, even when faced with unstable interest and inflation rates. Further, he claims that anyone can learn how to automate and manage their own investments, so you don’t even need a financial advisor to manage your money—meaning you won’t risk someone making bad decisions on your behalf.)
Use Compound Interest to Supplement Your Profits
According to DeMarco, instead of relying on earning compound interest as your only plan to build wealth, you should use it as part of a plan to preserve and build wealth. His recommended plan involves developing a profitable business first, then investing your profits to generate additional passive income. He argues that the more profits you invest, the more income you’ll generate—because compound interest dramatically increases the value of large investments over a shorter period of time, even when the rates of return are low.
(Shortform note: While it’s true that the more money you invest, the faster compound interest grows your money, generating wealth before you invest offers another distinct advantage: You can afford to take risks with your investments. We previously explained that diversifying your investments ensures the overall safety of your portfolio: Keeping your investments in cash, bonds, and low-risk stocks protects your money. However, as DeMarco argues, these options only offer a low return and limit the income you can make on your investments. On the other hand, having money to spare allows you to allocate funds to aggressive, riskier investments that have the potential to dramatically increase in value.)
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Here's what you'll find in our full Unscripted summary:
- Why the only way to achieve financial success is to adopt an entrepreneurial mindset
- Eight beliefs about money that prevent you from achieving wealth
- Actionable ways to adopt an entrepreneurial mindset
