A column in last weekend’s Globe and Mail implores readers to stop procrastinating and start saving money as soon as possible. A typical example is provided to show the power of compounding: Mr. Early invests $5,000 every year for 10 years and ends up with a larger nest egg compared to Mr. Late who started investing just 7 years later and continues to invest the same amount for 28 years.
While the example is very powerful, there is a bit of fallacy involved because the effects of inflation are completely ignored. In the example quoted in the article, Mr. Early invests a total of $50,000 and ends up with a nest egg of $496,055. Mr. Late, on the other hand, invests a total of $140,000 and his nest egg only grows to $476,695. If we assume that inflation runs at a modest 3% rate, Mr. Early’s inflation-adjusted investment is $120,000 and Mr. Late’s real investment is $226,000. Note that Mr. Late’s total investment is double that of Mr. Early’s, not triple as in the original example.
Investing early pays a rich dividend as evidenced by Mr. Early’s bigger nest egg despite investing only half of what Mr. Late did. It is just that the advantage, while still huge, is not as large as it is usually advertised.
Bookmark: del.icio.us Digg StumbleUpon
10 responses so far ↓
1 Phil S // Nov 30, 2006 at 9:20 am
I’ve always found these financial projections to be rather hokey anyways. The reality is that your investment returns are never as “straight-line” as in your projections. Some years you get a 25% return, other years you can get a -15% return. I think it is better to stay focused on minimizing your losses by putting money into the market at appropriate times, such as immediately AFTER a major correction and buying QUALITY stocks, meaning ones with a high probability that it will still be around when you retire. I don’t believe in making RSP contributions at regular intervals unless it’s going into some kind of a cash or money market account, waiting to be deployed at the times when your returns are likely to be higher. Of course, our wonderful government has made investing these days kind of a minefield with all of the unpredictable rule changes. Who knows what’s coming down the pike in the next few months? Now is the time to put RSP contributions in T-Bills or something until all these rule changes blow over. Then once we have the new ground rules, it’s time to decide where to put it. Of course, I got whalloped on the nightmare on Halloween, which I’m not soon to forget.
2 Canadian Dream // Nov 30, 2006 at 10:30 am
I’ve always had a problem with inflation. The government’s number always seems high to my personal situation. They base it on a basket of goods, some of which don’t apply to me (ie: tobacco). So my personal inflation number is usually in the range of 2%. So I tend to take inflation out of my retirement projections by lowering my rate of return by 2%. To date I’ve been using an adjusted 5%, since I don’t have a good idea of my long term average rate of return is.
3 Mike // Nov 30, 2006 at 10:38 am
Phil you make good points and I feel the same way. A huge part of the equation that is overlooked sometimes is how well you invest your money. Picking quality investments is harder than saving money.
4 Canadian Capitalist // Nov 30, 2006 at 10:48 am
Phil: Your point on future returns is bang on. Investment returns are always all over the map. You can probably count with your fingers the number of times the market returned exactly the average over the past 50 years.
5 Chris Hall // Nov 30, 2006 at 11:52 am
I have to agree with Canadian Dream on this one. As Canadian Dream and the book “Your Money or Your Life” by Dominguez and Robin says, the “basket” that is used to measure inflation may not apply to you. Sure a brand new car costs more than it did 10 years ago, but what if you don’t buy new cars. Has the price of used cars gone up the same amount? Also, some things actually go down in price (telephone long distance) that may not be included in the “basket”. The weighting of the items in the “basket” is significant too. Has the recent rise in gasoline significantly impacted how much you spend each month because you commute 2 hours a day, or do you walk to work and you don’t even notice the change?
I don’t have the answer for how to best measure inflation, but to take the CPI numbers at face value could be a disservice to yourself and your retirement planning. We don’t want to work any longer than wee really have to, do we?
BTW Canadian Dream - you’re website is showing good promise and it’s not even a month old. I’ll be following along.
6 Loki // Nov 30, 2006 at 1:09 pm
Sure - all of what’s in the “basket” referred to above may not apply to all - but all are better served by thinking in terms of worste-case-scenario. Perhaps the “basket” of goods that you personally are subject to may be even more inflated - who knows.
7 Rob // Dec 1, 2006 at 12:29 pm
I will weigh in with one comment on inflation. The means by which they calculate inflation tends to understate it (by about 1-1.5%/yr according to pieces I have read).
The reason is that CPI gets adjusted downwards to account for the improvements made in products.
The best example to describe this effect is computers. Simply put, if a new computer is twice as powerful as the old one, the government says the cost of computers fell by half. According the government, the computer you paid $5,000 for in 1995 is now worth $250 tops and therefore - they reason - the cost of living fell.
We all know the real world just doesn’t work this way. You can’t buy a $250 computer for example and expect it do anything.
As a result, CPI is regularly understated, and those planning their financial futures are well advised to add a percentage point or two to whatever the “official” number is.
8 Canadian Dream // Dec 1, 2006 at 2:42 pm
Rob - I agree. You have to include something to account for inflation while doing long term planning otherwise you will be in for a shock when you get there. It’s still rather funny when you think about it. We can’t predict if it will snow on the weekend with anything but a guess, but we still try to predict our retirements over 20 years from now.
Chris Hall - Thanks for the support and I’m glad you are enjoying reading my blog, but to be fair I have to give Canadian Capitalist credit for writing a great blog and inspiring me to give it a go.
CD
9 Matt // Dec 5, 2006 at 5:01 pm
You can’t discount inflation, this is a given but what if Mr. Early continued to deposit his $5,000 a year instead of using the money for buying a fancy car? Starting early and continuing the regular contributions to your savings will help you realize the full benefits of compound interest.
I’ve always found it annoying when such examples are given, why stop the investment? Keep going and you’ll be able to retire far earlier.
10 Dont Ignore Inflation :: Newstack // Dec 7, 2006 at 8:30 am
[...] Read more: here [...]
Leave a Comment