Non-intuitive Examples of Compounding Returns

http://blog.futureadvisor.com/42555581

by jonxu • 15 years ago

29 21 15 years ago

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WildUtah• 15 years ago

Of course, nobody can reliably get 5.04% after tax and after inflation compounding returns. (And nobody was able to over the long term in the Twentieth Century in passive investments.) If you put your money in the stock market over the past decade, for example, your return would be zero. And this is one of the best times to be cashing out. Most of the last decade would have produced negative returns.

Less risky investments like government bonds typically return less than 1% over inflation. If you intend to save for retirement and hope to benefit from compounding, you should be prepared to depend on 1% or less returns. One percent returns will double your money in seventy-two years.

If you want to retire on more than Social Security, you should be prepared to save every penny you'd like to spend. Compound investment returns have always been unreliable and the development of modern finance may have eliminated those returns forever by shifting all gains to banking executives.

Social Security is doing much better by comparison. Or you could get yourself a government pension; those are insanely generous.

thematt• 15 years ago

If you put your money in the stock market over the past decade, it's vastly over-simplified to say that your return would be zero. It's highly dependent upon what you invested in. I know many people (myself included) who have fantastic returns over a rolling ten year period.

nandemo• 15 years ago

Of course "it depends upon what you invested in" but your parent comment is referring to the market average or equivalently the return of an index fund. That's the only way it makes sense to compare the returns of different time periods. After all, in any period there are stocks that offer large returns but that of course doesn't make the stock market a sure bet since we only know the good stocks in hindsight.

ceslami• 15 years ago

The point of the article is sound nonetheless: it is better to save early and consistently.

This simple lesson alone could help many young people avoid financial issues later in life.

sabj• 15 years ago

Agreed.

While it is true that this kind of retirement savings is to some extent dependent upon good timing, what is clear is that if you have any ability to put compound interest to work - and I think that is relatively fair - it is much better to start early.

Even moderate rates of return will produce this kind of effect, and in that regard, I think it is a highly effective demonstration.

PaulHoule• 15 years ago

No, the "compound interest" meme is one of the most dangerous ideas that's going. Fundamentally, exponential growth destroys itself.

My model for economic progress is that there are two variables: the ability for a civilization to solve problems and the ability for a civilization to create problems. The benefits of growth are more immediately visible than the drawbacks, and because they differentially accrue to certain people, those people gain political power that is used to suppress the political response that would solve the problems created by growth. As a result, problems eventually grow faster than solutions.

When the ability of a civilization to create problems exceeds the ability to solve problems, we get an economic crisis such as the Great Depression, the stagflation of the 1970's or the situation that we're working through now. One way or another, the system needs a decade or so of low performance in order to slow down and sort out the problems that growth has created.

These crises seem to come every 40 years or so, so you're certain to have one, maybe even two, in the course of a career and subsequent retirement. And it just takes the aftermath of one to destroy your savings and possibly your career.

And, as the previous commenter says, if Wall Street has really turned into a system that captures all economic gains for a few people at the top, all you're doing is making them rich when you put money in a 401k or IRA. Personally, if I was President, the first thing I'd do is dismantle the 401k and IRA systems and let people withdraw all the money they have in them.

I'm convinced that tax-deferred savings have created a 'lost generation' of small businesses. It used to be people stacked up money in a bank and had it available when they wanted to start a business. If all of your savings are in a tax-deferred savings plan, you deprive yourself of that option.

whakojacko• 15 years ago

"If you put your money in the stock market over the past decade, for example, your return would be zero."

Another reason to look into a more balanced approach than just stocks. If you, for instance, put 70% in stocks and 30% in long term US treasure bonds and rebalanced at the end of ever year (simplicity of calculations), you would be looking at about 1.5x the amount at the end of 2010 from the start of 2000. Such an approach is likely to worsen your overall returns a bit (see: the 90s), but it also noticeably reduces the volatility.

orangecat• 15 years ago

If you put your money in the stock market over the past decade, for example, your return would be zero.

Not using dollar cost averaging.

riffer• 15 years ago

Even assuming dollar cost averaging, the return is negative after taxes and inflation.

anamax• 15 years ago

> Social Security is doing much better by comparison.

You're assuming that your younger co-workers are going to pay the benefits that Congress provides to current retirees.

My younger co-workers are pretty sure that their younger co-workers aren't going to honor those promises wrt them. My shoud I assume that my younger co-workers are going to honor those promises wrt me?

BTW - SS is only a "good deal" if you're well below the cap. If you're contributing at the cap, the return is much lower.

bugsy• 15 years ago

There are lots of articles like this. They seldom discuss the effects of inflation or properly plot things out on a logarithmic scale.

omh• 15 years ago

I agree about the effects of inflation, but why should things be plotted on a logarithmic scale?

rstonge• 15 years ago

If you have constant return (e.g. 5%) this will show up as a linear growth function on a log scale. It will be exponential on a normal scale, which over time gets very steep. Using a log scale allows you to compare the growth rates of different investments in a consistent way.

jasonkester2• 15 years ago

I give this same advice a lot, and it's always telling to watch people's reaction. Human nature is all about defending what you're currently doing, against all evidence that there's a better way.

So, yeah, it's impossible to get 5%? Are you sure about that? Over a 40-50 year period? You'd have to look pretty hard at old stock charts to find a spot where you could get overall returns that low.

And yes, inflation exists. It's probably still a good idea to save money for retirement though.

And yes, you're young and don't have as much money to spend. But you also are coming off a lifestyle where you shared a room with six guys and ate Costco ramen every meal for 4 years. As soon as anybody starts giving you money, it's money you didn't have before, so you absolutely can find a way to save it.

It's a lousy $1,000 per month. Figure out a way to stuff it into the market, and despite all your rationalizations, the 50 year old version of you will thank the 22 year old you.

Two9A• 15 years ago

Yeah, I've tried the whole stock market thing twice now. Put $1,000 in as a tracker against the market index, expected a decent return; of course, I put it in on Sep 10, 2001.

Never got that money back.

Thought I'd try again a couple of years ago, so I bought shares in Lloyds Group. On the eve of Lehman going south.

Never got that money back, either. I think I'll stick to 3% savings accounts, thanks.

jasonkester2• 15 years ago

As a quick test, you might want to go back and see where that disaster investment would be today if you'd left it in? Check again in 2041 and see if it beats 3%/year. You might be surprised.

And a quick word to the wise: Never "invest" in individual stocks. That's speculation, and chances are most of the time you do it you'll lose. "Invest" in a fund that tracks the S&P 500, and don't even think about taking the money back out until you retire.

mhb• 15 years ago

Where's a 3% savings account?

semanticist• 15 years ago

Lloyds Banking Group shares have dropped like a rock recently, but over the longer term they'll do well as the economy strengthens. The LTSB/HBOS merger has left them in a pretty dominant position for retail banking/financial services.

If you're only holding onto the shares for a short time and selling them when they fall, then you're not really doing it right.

nwomack• 15 years ago

While this graph is indeed accurate for a static income, for many people the income will increase over the years (on top of the inflation) which will cause difference to be a little less dramatic.

Regardless, save as much as you can as early as you can...

clistctrl• 15 years ago

This is so great in theory, I've ran the calculations over, and over again. However I feel like the question marks are never filled in.

1.) Put 1k a month in savings 2.) do ??? 3.) get > 3% compound interest 4.) enjoy a debt free lifestyle

where do i get > 3% return!

Non-intuitive Examples of Compounding Returns

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