I’m starting a series of pet peeves that I find in almost all personal finance blogs. One of the most amazing things you’ll read is how some small amount of money compounds at 10% over 30-40 years to some huge number. Here are just a couple of examples from some blogs that I respect quite a bit (they are both truly great writers).
The two dirty little secrets that no one wants to talk about are inflation and taxes. First off, let’s examine the 10% interest that’s often quoted. Often times over that time span, one would reduce the risk later in their lives. In fact, Getting Rich Slowly concedes “an 8% return-on-investment is more realistic over the long term.” The difference between 8% compounding and 10% is huge. It’s even bigger though, if we realize that inflation is 3.5%-4 a year, that 8% becomes a 4-4.5% gain. In other words, while you may have millions in 30 years, those millions won’t buy as much as they do today. And if we were to consider that some of those gains are in 401k plans (as they probably should be if possible), another 25-28% will be eaten from the 4-4.5% making it a 3-3.25% overall gain. Suddenly the 3400% gain over 37 years in the My Financial Journey chart is reduced to 327%. One thousand dollars doesn’t really become $34,000, but closer to $3,270.
That’s why I don’t like the many years of compounding example – it’s psychologically very deceptive. This is why it’s even more important to save. You can’t give up after one year just because the math looks amazing. Stick with it, and you’ll truly have a great nest egg.
I wholeheartedly agree. I especially have a distaste for the typical advice (on blogs and in the media) that says investing a certain small amount each month will get you to be a millionaire (it’s that easy!)… but by the time you’re a millionaire, $1,000,000 won’t amount to much thanks to inflation. (I’ve written about this several times. :-) )
J.D. @ Get Rich Slowly says
I have problems with assumed rates of return, too, as you note. It’s true that the stock market produces nice averages, even over short time spans, but these are not guarantees, and they assume that a person’s going to just leave the money be.
I’m currently reading a fascinating book called Yes You Can…Achieve Financial Independece by James Stowers. Despite the unfortunate title, this book is filled with no-nonsense investment advice from a professional with a public history of making smart choices. He stresses the de-valuation of the dollar, but also stresses that the only way to fight it is through compounding.
Look for a review at my site in the next couple weeks. (I have to actually finish the book before I can review it completely! :)
Lazy Man says
J.D., I’m okay with the assumed rates of 8%. While it is not a guarentee, I look at it like a casino does. They aren’t guaranteed to make money at any of their games, but you wouldn’t bet against them long term because the math is in their favor. In my book that counts as a virtual guarentee.
As for assuming that a person is going to just leave the money, that’s a psychological ball of wax that I don’t want to get into. I’m not interested in what the average person will end up doing. I’m more interested in what the truly motivated can do using math and a reasonable risk/reward scenario.
James is correct, the Inflation Monster isn’t going to go away just because you ignore it. Your only hope is to outrun it by smart investment choices and fighting fire with fire – or in this case compounding with compounding.
I look at examples like this as being much like cake.
When you’re little (in other words, when you’re just figuring out that you should be saving), you like the frosting. MMMM… it’s sweet! It also appears to cover everything. Just like the thought of being a millionaire! Compound interest, in other words, is the frosting.
When you get older (in other words, when you get the hang of things), you start to really appreciate the cake more. The cake itself actually makes up the bulk of the treat, and the frosting is there just to make it a bit sweeter. The cake, obviously, is the principal you add.
I feel such examples are fine and dandy if they encourage people to start saving. Obviously, when you become accustomed to a lifestyle of positive financial growth instead of just treading water or sinking, you begin to see that there is much more value in the cake than there is in the frosting.
Lazy Man says
Hmmm, I still like frosting much more than the cake. Energi Gal likes the cake. Are we talking about personal finance anymore? Sorry I got distracted.
The problem is that someone could think they are all set after seeing the frosting and stop saving after the first year. The other issue is a matter of trust. It feels like a white lie to not discuss the effects of inflation and taxes. If you are not giving the whole truth about this, what else is a half-truth?
While I appreciate your post about how compounding does not add up to what people say it will (taking into account taxes and inflation) just the mere ability to save anything by the average American is a miracle in and of itself. People are so caught up in the “I gotta have its” that they put aside saving until later in life…when its just too damn late to play catch up. But for the average person, putting aside $25 a week is better than putting aside nothing, no matter what the interest rate or the amount of years or whatever. I wouldn’t want to discourage someone from doing what they can even if its only a minor amount of money. But you hit the nail on the head; giving up after one year because the math looks safe is just the wrong way to go about saving. Its a constant life-long process!
I’m with you on the 10% compounding thing. But, you shouldn’t necessarily be so harsh on your fellow PF bloggers. They are merely parroting what they’ve read in books, magazines, and in the popular media. I read a book a while ago that strongly implies that if you stop buying coffee drinks, you would be able to invest your money at a 10% annual rate of return and end up with an astronomical amount of money. The author even trademarked the phrase, so I’d better not repeat it here lest I would owe him royalties…
Of course, the author never tells you where you can get the 10% annual return. He just sort of dances around the issue and mentions a bunch of brokerages and mutual funds. But, I didn’t find any of these guaranteeing me a 10% annual return.
My Financial Journey says
I agree with you whole-heartily that My Financial Journey has no idea what he is talking about ;-)
You bring up two very very valid points about inflation and taxes. While I did ignore them in that post (mainly for just trying to extol the power of compounding – which was probably wrong) I have tried to address what a realistic rate of return was in some other posts, probably should have added a disclaimer in there saying 10% after taxes and inflation is nearly impossible, but it was geared more towards being a motivational post to START investing NOW than to say here is what you should be expecting for returns and well 10% looks way cooler than 5% (actually the post originally had 3 columns with 5%,8%, and Warren Buffet%, but I just settled with one 10% column for simplicity and focus on the power of compounding)
See my incomplete set of posts on A realistic Rate of Return (part IV which has been in my draft section for many months focuses on inflation :-)) I’ll try to push it out soon now that I have been called out :-)
Realistic Rate of return here http://www.myfinancialjourney.com/index.php/archive/realistic-rate-of-return-part-1/
PS Absolutely no hard feelings about this post – I’m glad you did this and this is why I blog to get feedback like this. Plus it proves that someone actually read my blog ;-)
English Major says
I’m all for personal-finance blog pet peeves! (I basically started blogging because I was so irritated by all the “don’t major in English!” advice.)
I’d agree with Trent: these sorts of exercises are effectively financial evangelism–the idea is motivational, rather than pragmatic.
Ramit Sethi (iwillteachyoutoberich.com) says
I think there’s some nuance to the argument. First, I agree that most bloggers don’t mention taxes and inflation (I haven’t touched upon those issues very much because they’re complicated and make people’s eyes glaze over). Before adding more complexity to the issue of investing for the long term, I want people to understand the basics.
But there are two other things to consider.
First, there are lots of tax-deferral strategies that mitigate the effect of taxes. Things like 401(k)s and Roth IRAs are fantastic investments (as I wrote about in The World’s Easiest Guide to Retirement Accounts. And as you acquire more money, you can structure your accounts differently to optimize.
Second, what’s the next-best alternative? Sure, taxes and inflation will take a bite out of your earnings…so, what’s your suggestion? To not invest? To invest only in inflation-protected securities? Even though taxes/inflation reduce real earnings, investing in the stock market over the long term is still the most reliable way for regular people to make money over the long term. It seems to me that people need more motivation and education to save/invest more. My point is that, as a blogger, I’d like to help people learn the basics, then point them to places where they can find out advanced information about taxes and other optimization strategies. First things first.
Adventures In Money Making says
assuming you get 11% in a tax-deferred account and consider 3% inflation.
isn’t that the same as getting an 8% compounded yield?
if its not tax-deffered, just make sure you have passive activity phantom losses to offset the gains, like real-estate depreciation.
I wish I would have seen this back when you first wrote it.
I like to speak in generalities when I’m talking about long-term rates of return. I’m also fond of using the 10% return because I have 80 years of returns to back it up.
Inflation is tricky because people don’t understand it.
People who deliberately lie, excuse me – stretch the truth, to try to sell their ideas don’t attract me to their ideas. They turn me off them. I know about things like inflation and taxes (geez who doesn’t?), and if the bloggers wish to ignore it, I tend to dismiss their entire point of view as being so much pie in the sky, nothing to do with reality.
I can understand the sentiment, but I think that the purpose of JD’s article was to motivate people toward saving (as mentioned by Trent). Inflation and taxes should certainly be mentioned, but explaining the actual effects of both of them appear to beyond the scope of the post.
Where’s my edit button.. “appear to be beyond the scope of the post.”
Yosef Katz says
Lazy Man I have a problem with your peeve! You state that x% compounded is not the true future value because it is subject to inflation and taxes. But isn’t all money earned subject to inflation and taxes? So doesn’t that make it a wash? So if you are comparing spending to saving, saving simple to saving with compounded interest, saving with compounded interest to an investment (and calculating risk, can we?!) that yields x% it is all the same as they are all subject to inflation and taxes, right?! Or did I miss something?
So the “remedy” for this might be to just discount the projection by a projected inflation rate (which may be a fuzzy number!) and the tax rate expected, and then one can extol the virtues of compounding?
Lazy Man says
Yes, but it how most magazines make it sound like you are getting huge numbers with 10% compound interest and it turns out that you really aren’t. It gives a false sense of security.