Compounding your return on investment is a tiny factor in wealth building compared to how much and how often you save money.
By: Francis Kier
The biggest gripe that I have with a few famous financial planners is their myth and awe of compound interest. They say, “compound interest is the 8th Wonder of the World according to Einstein, and will make you a million for your retirement if you’d only skip a few trips to your local coffee shop!!” In my opinion, compounding your return on investment is a tiny factor in wealth building compared to how much and how often you save money.
Growth charts used by the people struck by compounding ignore all forms of taxation, fees, commissions, inflation, and then misleadingly uses an average return of 10-12%.
Let’s start with the average stock market return of 10.7% This return rate is the most frequently published number to reflect a stock market average. There are many problems with market averages, but the 10.7% is not any kind of accurate annual compounded growth rate. As an example, if the stock market has a loss of 10% one year, and a 20% gain the next year, these zealots say that the average return for these two years is +5% (+.2-.1)/2). This is a mathematical failure to add. The correct return is only 3.9%, and again, this doesn’t include fees, commissions, taxes and inflation. How are you going to compound your money when the stock market starts one of its frequent 5 year droughts of moving down and sideways (’73, ’81, ’87, ’00). The after-inflation Dow Jones Industrial Average annual return for the last 55 years is only 4.8%; plug that little number into your calculator for 10 years and see how many Rolls-Royces you can buy.
Your growing portfolio will either be in a taxable account (knock another 25% off of your annual compounded growth rate for taxes) or in a qualified retirement account. The zealots talk about qualified accounts like everyone can have them, but there are mazes of rules for who can qualify for certain programs, how much they can invest, and even a ceiling to how much can be put in them. Sooner or later every dime of these accounts will be taxed as well. And when the baby-boomers start emptying the government’s social security account in 2014, tax rates on these retirement accounts are not going to remain low. Politicians will take the easy way out and simply tax these retirement accounts to make up any deficit. The point is this: when money is in a retirement account, it isn’t yours until the government taxes it and releases it to you. More reference material for this article is available at the website below.
If you start playing around with realistic compound rates, the serious increase in earnings doesn’t start until after 50 years. So unless you are a 4 year-old with $50,000 in the bank and have the discipline to never spend it, even the concept of compounding is fairly irrelevant for your financial future. Today, half of the 50 year-olds in the U.S. do not have $50,000 in retirement assets. Even skilled investors are unlikely to build that into a tidy $2,000,000 by the time they turn 65.
The compounding that pays the most is the addition to your savings over time and investing skill. If you don’t continually add to your accounts, they can not add up to much; “No big money in = No big money out.” And if you don’t continually accumulate investing skill and knowledge, you won’t be able to keep your money growing faster than inflation is destroying it. Please note that there are no books titled “How To Get Wealthy By Putting Some Money Under A Mattress.” Your money has to be invested and earning interest above the inflation rate or you are getting poorer.
About the Author:
Francis Kier has an MBA in finance and shares his two decades of experience with investing and finance. More of his articles are available at http://investing.real-solution-center.com.