Compound Interest and Passive Income Are Overrated

When I first started investing seriously, I did what everyone else does.

I had fun in the spreadsheets. You can dream big dreams in there. It is very exciting. Don’t like what you’re seeing? Just type in a different rate of return. Your partners in this cosplay are compound interest and passive income. A number here, an online calculation there, and you’re going to be wildly wealthy.

It is lewd, but true: compound interest and passive income are the kinks of personal finance. There isn’t an investing book in the past forty years that doesn’t fetishize them. Their primary purpose is not to get you rich, but to make other people rich getting you excited. Beware. It isn’t real.

Compound interest does all the work, growing your wealth faster and faster. Compounding creates net worth; bigger is better. An impressive net worth attracts passive income—money you make in your sleep. You don’t even have to work for it; it just shows up and wants you to have it. You can then send the passive income back to compound, and around we go.

Except for those tiny few uber-rich who simply can’t outspend their returns, none of this applied to everyday people for most of time. In history, compound interest had little power. Passive income did exist, but is now more a fond memory. When you stare at them closely, most people touting the transformational power of compounding and passive income are just playing pretend. Nearly every personal finance personality made their fortune doing something other than compounding regular returns and soaking up passive income. They’re hoping if you stare at their assets long enough, you’ll forget they’re fake.

Let’s start with the fact that these concepts contradict one another. You can’t have passive income and compound interest at the same time unless you start off very rich. If you use the income, it doesn’t compound. If it’s compounding, you’re not using it. You can’t live on something that’s growing and you can’t grow something you’ve killed.

The appeal, of course, is that pornography makes everything look so easy. There isn’t all the awkward trying to figure it out, the risking rejection, the mistakes, the “sorry, that didn’t work, let me try something else.” That is the tell, and once you spot it, you’ll see why personal finance seduced many people before you. Nothing that ends so amazing could ever be that easy.

Should we ignore the powerful draw of personal finance fantasies? No. They definitely grab your attention. Don’t discount excitement. It is necessary. It helps us take risks. It lets us speak out loud what we were embarrassed to say we really yearned for. Maybe it’s a house with a yard. Maybe it’s a Maserati, I don’t judge. You do you. Just remember that dreams do not make themselves come true. Real people do. Stop dreaming of being a millionaire online. Become one in the real world, and don’t expect compounding and passive income to do everything for you. You have to put in the work.

* * *

The power of compounding interest is less magic and more magic show. In Lewis Carroll’s follow up to Alice in Wonderland, he tells of a poor tailor whose rich client dupes him out of his pay. Offering the tailor double next year, the small bill builds and builds until it is £2,000 (around $300,000 today). Just as he pretends to pull out that extreme level of cash, the wealthy man casually suggests the tailor could double the bill again next year. With that much money, a man could live like a king! Off goes the tailor to await even more riches. “Will you ever have to pay him that four-thousand pounds?” asks a young girl.

“Never, my child! He’ll go on doubling it till he dies.”¹

Like most fantasies, compound interest wasn’t even useful. For most of U.S. history, getting ahead had nothing to do with compounding. Compounding requires two things most everyday people did not possess: limitlessness and time.

Most pioneers’ wealth was in land. Land does not compound. It only grows valuable when you add labor. Sure, Americans could hold that land for a price rise. But the real way to build income was annually adding more sons to the family so you could clear more land with those sons. The average adult could harvest seven acres per year. Seven sons meant fifty-six acres (including Dad). But this growth wasn’t infinite. There is an upper bound created by available land, willing wombs, and the expiration date on growing kids who leave home. Wealth was constrained by how much labor you could apply in a short window. Compounding doesn’t have ceilings, but real life (and real estate) does.

Much of what looked like hardy families getting rich slowly wasn’t compounding anyway, but increasing demand for a limited supply. More and more people flooded west, increasing the value of the farms already owned. Ever larger cities increased the demand for what farms could grow. Acreage wasn’t compounding into more acreage. It became more valuable per acre.

There is a myth that compounding is what made the Baby Boomers so wealthy. Partially, this is true. Thirty percent of Boomer wealth is of the stock market variety. Yet, almost as much is in real estate, where values exploded upward because it didn’t grow. Supply got restricted, making the houses we have cost ever more. The reason Grandma’s bungalow in Scarsdale is worth a cool million isn’t compound returns, it’s that you can’t build in Westchester County anymore.

Then there is time. Compounding is very simply the math that happens when you multiply a thing over and over again. One hundred dollars with 5 percent returns makes you five bucks. If you don’t spend it, next year you get to multiply by $105. Fast forward over half a century and you’ll earn over $50 because your balance is more than a thousand. And on and on it goes until you are rich with the poor tailor.

For this to work you need time, preferably lots of it. Early Americans had little. The typical American wasn’t going to live to forty-five, much less sixty-five. As Morgan Housel observed, 90 percent of Warren Buffett’s net worth² was made after his sixty-fifth birthday, an age most Americans never saw before World War II. Time was not on their side.

We live longer and our wealth isn’t planted in corn rows. Surely things are different now, right? Not as much as you think.

Warren Buffett became wealthy from compound interest because he didn’t live on the compound interest. The fifth-richest U.S. citizen lived, believe it or not, on a $100,000 annual salary from his company. This he spent on lunch—daily at McDonald’s no less—and expenses. He paid off his home in 1973 and never moved. The compounding was so powerful because he didn’t use it. As his business partner, Charlie Munger, liked to say, “The first rule of compounding is never interrupt it unnecessarily.”³

But necessity calls often. On paper, it can’t be stopped. But the compound interest plugged into the spreadsheet never runs off with someone from work and splits your assets in two. It never begs the doctor to do anything, anything it takes to save your premature baby. It never gets laid off, never forgets to pay a bill, never gets rear ended by an uninsured driver. It never hears everyone at work saying the market is imploding and you better get yours out while you have something left. The most common reason Gens X, Y, and Z report not having enough retirement savings is that they tapped 401(k)s in emergencies or market panics.

Compound interest gets interrupted all the time. As long as it stays in a spreadsheet, compound interest will be undefeated. But it is a paper champion: amazing at practice, but always underperforming in the game.⁴

* * *

Passive income, meanwhile, was never a way to get rich. It was a way to live off riches. Today, it is sold as the ultimate goal of personal finance. True, people in history did have passive income, and many people lived off that income. There are two problems today, though. First, most of what looks like passive income is actually something else. Second, passive income was murdered, and the killer is still on the loose.

Let’s start there. In the long centuries from 1600 to 1900, stock dividends and bond interest payments did pay some people’s bills. Remember, inflation was functionally 0 percent from after the Revolution to World War I. Five percent bonds in a 0 percent inflation world is a great way for Grandma to sit by the fireside in peace.

The folks who lived this way were called rentiers, because they basically rented their money out the same way landlords rent a house. But starting in World War I, and going all the way to the present, passive income gave you less and less because inflation rose more and more. John Maynard Keynes called this the “euthanasia of the rentier,” a gentle killing. Later thinkers called it a “murder-suicide,”⁵ since the longer old folks lived, the more of them that were still alive and renting out ever more money. The supply of money to rent became so large, the profits from rent-a-dollar went way down. Whichever way passive income died, it wasn’t pretty.

When I listen to today’s financial advisors talk, I stand up and have my Princess Bride moment. “My name is Dr. Joseph Moore. You killed Passive Income. Prepare to Die!” Oops. Wrong line. “You keep saying that word. I do not think it means what you think it means.”⁶

Most of what passes for passive income today is just successful speculation. If your stock goes up 10 percent, and you sell half the gains to pay bills, it wasn’t passive. It was speculative. Passive income involves no work, but it also involves little risk. Stock rises are not a guarantee. You bet on up . . . and up it went. If you had bet on up, only to watch it fall, you have no income.

The real math on passive investments isn’t the return (i.e., 5 percent). It is return minus taxes minus inflation (in that order). A 5 percent return minus federal and state taxes leaves about 3.5 percent. If inflation is 2.5 percent then you made 1 percent. If you’re trying to eat 1 percent, you will dine on canned tuna. If you try to compound 1 percent, good luck getting rich in one lifetime.

* * *

There is a sliver of good news, though. Just as most of what looks passive today is not, so too most of what looked passive in history wasn’t either. And it wasn’t speculative. For most people, their money was active.

Manuals as early as the 1840s were explicit: “Nothing is so fatal to success as the belief that a business, any business will run itself. It won’t.”⁷ That sentiment was universal in most of American history. The dream that you could own a company requiring no effort and collect checks was a pathway to poverty. “Not to oversee workmen, is to leave them your purse open,” Ben Franklin said even earlier.

The most successful retirees and widows worked at their investments, interviewing mortgage applicants in their parlors and asking overly personal questions about the health of the business and the marriage. They mentored the junior partners who took over their shops. They visited their rental properties to make sure they were tidy.

Everyone wants to get rich by doing nothing. You won’t. It doesn’t work to take value without giving it.