According to Albert Einstein (or so legend has it), "Compound interest is the eighth wonder of the world." In other words, it's wise to reinvest your interest so it can earn interest. This can accelerate how quickly your money grows. Compound interest, coupled with time, can be one of the most powerful wealth-building tools in investing.
But that isn't the entire quote...
Here's the rest -- the part most people tend to neglect: "He who understands it, earns it; he who doesn't, pays it."
Compounding works both ways. Just take a look at your next credit card statement. Credit card companies are required to show you how long -- and how much interest you would pay -- if you only made the minimum payment each month. And that's assuming you don't ever use the credit card again.
It's important to understand compounding, especially considering the fact that household debt in America hit an all-time high of $1.021 trillion in June, the most recent data available. The last time debt was this high was in 2008.
But I digress.
Compounding interest is a great and powerful tool. But it's often misunderstood. You see, compounding only works when you don't lose principal. When you have devastating market collapses, it inflicts long-term damage to the "eighth wonder."
It took over a year for the market to recover from its most recent pullback (from May 2015 to February 2016, stocks fell nearly 14%).
Or look back at the financial crisis when the market peaked in October 2007 -- and subsequently lost 56% of its value. It took roughly six years for the market to recover.
And here's the kicker... none of those recoveries takes into consideration inflation. Once we adjust for inflation the picture is even grimmer:
Adjusted for inflation, it took 14 years for the S&P 500 to recover from the dot-com bubble. What's more, if we look at the Nasdaq Composite, it still hasn't recovered from the dot-com bubble...
My point is that compounding works when you are generating a return greater than zero. It only takes one good market crash to wipe it all out. And as you can see, it can take years, even decades, to recover. Again, it doesn't matter how powerful compound investing is if the foundation of your investments is crumbling.
This is why I constantly pound the table on cutting losers short, capital preservation and reducing risks. It's also why I'm such a firm believer that in order to effectively build wealth through investing, one must adhere to some sort of buy and -- more important -- sell rules like my subscribers and I do over at Maximum Profit.
Understanding that we must not lose capital in order for compounding to work is the first step in making the "eighth wonder" work for us, instead of against us.
Where The Biggest Gains Can Be Made
I recently wrote about the warning signs that are indicating that this great bull market could be nearing an end. More specifically, I said, "The cracks are beginning to show... but I don't believe we're there yet."
Since then, we have seen an uptick in uncertainty as measured by the CBOE Volatility Index, or VIX. At the time of my warning in August, the VIX was near all-time lows. But ever since, it's been on a roller coaster ride. It spiked over 20% in the last week alone.
Yet despite the early warnings signs, the Maximum Profit system is still finding stocks to buy. And instead of shying away, I am going to continue riding this market higher, until the system tells me otherwise. After all, some of the biggest gains can be had in the late stages of a bull market...
The last great bull market run that we had, like the one we're in now, came during the 90s. The S&P 500 and the Dow Jones Industrial Average soared over 300%, while the Nasdaq 100 skyrocketed roughly 2,000% leading up to the dot-com bubble. In the current bull market, the S&P 500 is up more than 260%. The Dow Jones Industrial Average is up 230%, while Nasdaq is posting a gain of over 470%.
During the 90s, the biggest gains came in the late stages of the bull market. For instance, in the 18 months leading up to the market peak in March 2000, the Nasdaq soared 270%. What's more, in the final five months the Nasdaq rallied nearly 90%.
I can't guarantee that we'll see these kinds of monumental returns this time around, but the point is that during the late stages of a bull market (during peak euphoria), that's when the biggest gains can be had. And my Maximum Profit subscribers and I don't want to miss it.
Of course, we won't catch the very top of the market. No system has timing that precise. But if this bull market does what it did in the late 90s, then we will catch the bulk of it, and more important, miss the bulk of the downside. And it's all thanks to a system that gives clear signs of when to buy and sell.
This is why, despite early warnings signs, my subscribers and I will continue to add stocks to our portfolios and ride this great bull market. But you can be sure that when things turn south we will quickly sidestep and miss most of the turmoil. We will adhere to the rules of the system.
If you're tired of wondering when this bull market will end -- and whether to buy or sell -- then I can't stress enough how important it is to establish a clear set of rules and to have a powerful system working for you. That's why my publisher and I would like to offer every investor the chance to give the Maximum Profit system a risk-free trial.
This article originally appeared on StreetAuthority.