- Comments (14)
- Text Size: Down Up
moneysense.ca, 1/09/10
From the archives: Fun with Numbers
[One often runs across articles in the popular press that purports to show how much ahead one can get in the retirement game by starting to save 10 years early. While establishing a savings habit early and allowing time to do its compounding magic are worthwhile goals, these articles overstate their case by ignoring the time value of money. It is true that investment returns compound over time but at the same time inflation is forever eating away its value. When you account for investment returns but don't subtract the effects of inflation, you end up with a very distorted picture. A recent post on this topic by Michael James reminded me of this post that was first published here in June 2005. Note the overly optimistic and rather naive assumption of a 9 percent real return.]
Fellow blogger JLP recently posted about the advantages of investing early in life. By starting early, we can allow compounding to work its magic. Time literally is money. However, along with our investment, inflation is also compounding and eating into our returns.
So, I took JLP’s numbers and plugged them into Excel and added a twist: I am assuming annual returns of 12% and an inflation of 3%. Here are the results:
Early Bird, who started investing $3000 every year starting at age 25 has a portfolio of $143,651 at age 40. But, instead of $48,000 in nominal dollars she has actually invested $62,284 in real terms. Actual return is 230% compared to a nominal return of about 300%.
Slow Poke, who waited till 30 and invested $3000 every year thereafter until age 40, has a portfolio of $69,399. He has invested $33,000 in nominal terms but only $39,576 in real terms. Slow Poke’s actual return is 175% and nominal return is 210%.
Admittedly, Early Bird has a big headstart. At age 65, she will have $2.44 million whereas Slow Poke will only have $1.17 million. Starting to invest early pays rich dividends, only it is a little bit less than we think.
moneysense.ca, 1/09/10
Interesting twist that is usually missing from most “it pays to start early” examples.
However, for me the big takeaway I get from reading articles such as this one is to keep me motivated to save and invest consistently.
Even though inflation eats away some of the gains, I suppose it never hurts to be reminded to start saving now!
I agree with most of the above post, the earlier you save the better. But, when taking the simple illustration to the next level and account for inflation, it might be prudent to take it even further and look at the actual amount invested each year. It is unlikely that an individual would invest the exact same amount each year for the life of the investment. In the real world salaries increase not only with inflation, but with experience and education. I would think that this salary increase would more than make up for the losses experienced by inflation as long as the amount invested is pegged to what is earned, eg. 10% of salary.
So, maybe another tip for investors is to not turn a cold shoulder on updating your regular investment plan when receiving a raise at work!
@CC. I think that your 25 yr old has 5 yrs more of accumulated principal investment, which kind of throws off the numbers. So, here’s a wrench for you to throw in to the calculations…
What if 100% of the money invested is really done through an RRSP. Then, you consider that the 25 yr old has a much lower salary and hence tax rate than the same person 5 yrs later. Since during the 5 yr time period, the same person may accumulate that unused RRSP contribution room, then the same person at 30 may accelerate their contributions and be able to write off more of their taxes (due to the higher income / higher tax rate).
I haven’t run the numbers, but I expect that the person at 30, due to the higher tax recovery, may be able to make up for a lot of the time lost if they accelerate their contributions, due to the tax advantage of contributing in their later years. In order to compare apples to apples, it needs to be assumed that you get the same principle amount, so the 30 yr old would have to (and be capable of) larger payments.
Of course your 12% rate of return seems a tad aggressive. I’d have to try calculating my “average” rate of return for curiosity some day because I’ve been all over the board. I’ve had some investments go up 600% and I’ve had some go to zero. It’s that “head on fire and feet with frostbite” thing for me where I’ve never figured out what I’m averaging.
@CC: It’s amazing that my post matches yours so closely (other than the return assumptions). Maybe I would have used rosier numbers in 2005 as well.
@Tiny Potato: The problem I have with typical “start early” articles is not that they don’t have a very good point. They do. But, investors should also be realistic. IMO, these articles convey a too-rosy picture, setting up investors for disappointment.
@John: Yes, that’s a good point. It might be better to simply work with inflation-adjusted numbers. Then not increasing contributions won’t be much of an issue (though investors probably tend to save more later in their life). Of course, inflation-adjusted investment returns would be rather low. Probably 3 to 4 percent.
@Phil: One more point to add to your own is how lumpy stock market returns are. It is always possible that someone starting off at 25 isn’t all that farther ahead than someone starting off in 35 if the latter happens to luck upon a sequence of returns that puts her ahead.
@Michael: Yes, I was chuckling at the 9 percent real return assumption. If investors on average can make that kind of returns, Buffett wouldn’t be all that special at all.
@CC. LOL! Yep, that’s true, the 25 yr old at the time could have put all his eggs in the Nortel basket…
I guess one should always compound net real returns (net after inflation and expenses).
It’s difficult to beat the index so I doubt one can achieve even a 6% net real return.
With such a low rate, I suggest you start while you are still in the womb.
@Sean: Yes. I’d also add another net to that list — net of taxes. So, after inflation, taxes and expenses, investors will probably be lucky to end up with 3% real returns. And at that rate, it will take 24 years to double an investment.
[...] This post was mentioned on Twitter by Canadian Capitalist, bigcajunman. bigcajunman said: RT @CCapitalist More Fun With Numbers http://ow.ly/2xOAB Again, Lies, Damn Lies and more fun with numbers [...]
CC
Reminds me of The Wealthy Barber’s discussion: “Sure, inflation is going to have an impact ….[but] inflation is all the more reason to save. Things are going to get more expensive …. Remember that your wages will continue to rise, too, as will your ten percent saving.”
I would like to know where this 12% is coming from? Introduce me to a person out there that’s realizing a consistent, annual average return of 12%?
The average investor is duped into buying Mutual Funds, 80% of which under perform the market, plus charge 2%-3% annual management fees, plus DSC fees! If after all that you average 4%-5% consider yourself lucky.
We all know the effects of compounding interest, it don’t take a genius to know the more, the earlier, the better. The real question is how do we achieve a substantial consistent return?
The next question is how do we minimize the tax implications of our nest egg?
I’ll give you a hint….. It’s not RRSP’s
@Tareq: Your website says — “There is no sacrificing safety for return…”. Really? Finance 101 says that risk and reward are linked. Anyone who claims otherwise has, IMO, lost a lot of credibility.
[...] showed that numbers are fun to play with, but aren’t the only part of the Finance answer in Fun with Numbers CC shows how you can get a little optimistic about things, whereas, Michael James posts More [...]
I don’t care what finance 101 says, and may i remind you i have an International Degree with a major in finance. I endorse am investment strategy that has never not paid an annual dividend in over 150 years, and the returns have outperformed the stock market 30 yr average. So what does risk vs reward have to say about that?
How about implementing solutions to increase your Internal rate of return? What’s the risk of legitimately reducing your annual tax consequence by 20%? Isn’t saving 20% better than chasing a 12% return in the stock market and risk losing 50% or more?
“Financial Advisors” are so entrenched in their conventional beliefs that as soon as someone says anything opposed to what they learned in Finance 101 “they aren’t credible”.