Power of Compounding?

I'm familiar with what the theory is about, but I was wondering about the fact that most models of the theory are based on a certain interest rate. Say 10%. I understand attaining this amount has something to do with asset allocation, but is there a way to garner that 10% with very minimal risk? For example, putting it in a money market fund?

I love the rule of 72, and i know in Einstein's own words this is the most powerful concept in the universe (and he discovered nucleur power). But i'm really looking for the most effective way to harness it's power with the least risk.

The performance measures of portfolios (sharpe & treynor) are all determined as comparisons against the tax-free rate of return generated by 30-day treasuries which has the least market risk. Any %age point of return higher than this rate of return typically comes with additional risk. The more risk, the higher the return.

If you look at the Ibbottson return studies, you'll see that in order to garner an AFTER-TAX return of 10% you'll need to put the risk of small-cap stocks heavily into your portfolio mix over a long period of time, otherwise 10% is quite difficult to attain.

Rules are great and assumption return rates are also great -- as long as you can actually achieve those returns.

The best way to achieve this type of return is to look to get a mixture of capital gains plus dividends into your portfolio return mix -- this way you're not reliant on the market shooting up 10% to get that return. An appreciation of 6% with dividends of 4% would do the trick for you, this is typically a more established company, not a 'small cap' company.

Since dividends and interest pay out at least 4 times per year, every time you get this income, it is added to your principle, so each time, you get a little more interest or dividends. It adds up as the years go by. Utilities are good stocks to own for this, they are usually very stable with good dividends. Hawaii Electric Company (HE) and ExxonMobil (XOM) are two very good examples.

I personally own Exxon (XOM) and it has been nice reinvesting the dividends. GE is another great company that pays a nice dividend. Overtime, the appreciation of the stock in addition to the dividend may yield 10% or so. REITs usually pay a higher dividend. Check out SPG and GGP.

First of all, learning the Rule Of 72 is good knowledge for every investor to have. The rule of 72 is a simple way of estimating the amount of time it takes to double your money.
You simply divide 72 by the rate of appreciation and you have the approximate number of years it takes to double your money. For example at a 10% rate of appreciation it takes about 7.2 years to double your money, and at 5% it takes 72/5 = 14.4 years. At a 30% appreciation rate you double your money every 2.4 years.

At the same time you can use the formula the other way, to double your money every 5 years you need an interest rate of 14.4%.

The "proper" formula for calculating gains is (1+i)^n where i is the interest rate (as a decimal, ie 30%/100 = 0.3) and n is the number of years. A 7% interest rate over 5 years leads to a gain of (1+0.07)^5 = 1.4, ie a 40% increase. To set a profit target for your money use the rearrangement of the formula: 1+i = nth root of gain, so to quadrupal your money in 3 years means taking the cube root of four and subtracting one, ie 3root4 -1 = 0.58, you would need a gain of 58% a year compound.

Applying this to a rule of 72 problem just to check, the rule of 72 says that it takes 8 years to double your money at 9%. (1+0.09)^8 = 1.99. Pretty close, which shows that the rule of 72 is a very good quick calculator, but not an exact solution.

Guarantees about getting high returns are another story. I invest a certain amount of my money in more risky higher yielding funds -- that's what I am able to lose if it doesn't pan out like I want. But I invest most of my $$ in real estate because of the amazingly high returns on such a small investment due to leverage.

Good luck