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A Victim of the 10% Compounding Myth

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A couple of weeks ago I presented you with The 10% Compounding Myth. A few people brought up in the comments that the examples are used as a tool to encourage people to save. I applaud that endeavor, but I wish we could do it with real math.

What happens when you don't? Meet Luke and Hannah Wickham courtesy of USA Today. The couple is doing extremely well financially, far better than most. You can tell they've been ready their Kiplinger's and/or Money Magazine. However, they have lofty goals - perhaps too lofty.

"The planner points out that the couple would actually need $18 million upon retirement to have the spending power of $10 million today, assuming a 3% annual inflation rate. This insight is eye-opening to Luke, who admits he 'really hadn't thought about the time value of money'"

I think 3% is a little conservative for inflation, but the point is the well made. We all need to start think about the "time value of money."

Posted on January 11, 2007.

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2 Responses to “A Victim of the 10% Compounding Myth”

  1. Rich Slick says:

    I think there is more to the myth than just the 3% inflation rate. If that 10% return is a mutual fund does it include the Mutual Fund Fees? These fees & expense ratios usually run 1% to 3% on top of the inflation rate.

    So in order to really earn 10% you need to factor:

    1. Three percent inflation
    2. Two percent management fee / expense ratio
    3. Taxes?

    So 10% 3% (inflation) 2% (fees) = 15% (does not include taxes!)

    When people finally get around to understanding these numbers a light will go off in their head and they’ll switch to ETFs (low fees) and inflation hedge (options) which also provide dollar cost averaging, tax efficiency, and diversification people often seek.

    If history is any indicator, ETFs will become dinosaurs when the average Joe starts putting his money in them, then it’ll be time to move on to the next big thing.

  2. Lazy Man says:

    You can get by a lot of the fees with Zecco and either ETFs or just straight stock purchases. I don’t see ETF going away or raising expense ratios. If anything, they should go lower as more people invest in them. Of course Vanguard funds are also low expense and people have been investing in them for years.

    And the first $4000 can be in a Roth IRA, so you would only be taxed on it once (when it was earned).

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