323.8
8.Your friend notices that $1000 invested in small stocks in 1926
would have grown to over $1 million by 1990. He says, "Hey,
wait a minute--the annual return on small stocks has averaged
only 18% per year over that period. 18% of $1000 is $180, so over
those 64 years, the $1000 could have only grown to $12,520 [=1000+(64*180)].
Is this one of those investment scams?!" While you're
floored by your friend's knowledge of historical returns, you
feel obligated to explain where he's gone wrong in his analysis.
Do so in the space below. (4)
Your friend is only looking at the return on the original $1000 investment. He’s ignoring the fact that after a year of 18% return, your investment will have grown to $1180. The next year, if you remain fully invested and continue to earn 18%, you will earn 18% on the full $1180, leaving you with $1392.40 and so on. In other words, you friend has forgotten about the effect of compounding or earning interest on interest (or return on return).