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.