These Piggies Went to Market
You know the advice. The “Power of Compound Interest.”
“Start saving young. Look what you can create.”
To illustrate, using Nerdwallet’s tool.
Put $1,000 into an investment account, save an additional $100 every month, and earn an annual 10% return.
After 40 years, the accumulation is $686,108. That hard-earned cash you saved: $1,000 plus 40 years of $100 monthly payments = $49,000.
$49,000 for $686,108.
Incredible on the face of it. Not incredible if eggs are $30 a dozen, a pound of bacon is $36, and a personal trainer costs $1,200 an hour.
Add This Knowledge to Savings Illustrations
Those who promote a monetary compounding effect swing and miss. Depending on how you frame investment return performance, stock return performance can fracture the compounding narrative.
Investments with 10% returns, like a broad portfolio of publicly traded stocks, don’t trace out a smooth line. Returns are variable, unlike the green curvilinear line in the graph. In fact, actual performance for investments with a 10% average historical return presents a very jagged line. Smooth means “for sure” and that is not the stock market.1 The last month’s financial news about the stock market is a breath-taking sucker punch that illustrates the variability.
Nothing in the quoted rates explicitly considers inflation. Advisors, financial institutions, and financial influencers will quote or illustrate future rates in nominal terms, e.g., 11% on the S&P 500 ETF. Or a less risky investment, the high-yield savings account, will earn 4.25% this year. The “Truth in Savings” law requires reporting an annual percentage yield (APY), which is a nominal rate.2 A couple of years ago, 6% inflation and a 4.25% nominal return on bank savings were not a great time to save. Savers were losing by saving.
Real investment returns give savers a better idea of whether they are keeping up with purchase costs. Thinking in “real” terms keeps purchasing power in perspective. Knowledge about real returns is more informative, but at a given moment, it can make you more or less comfortable. Locking in a 3% real return on a low-risk, non-volatile investment comforts retirees. A persistent -1.75% real return (4.25% - 6%), puts everybody on the edge of their seats.
Savings and Real Returns
Returning to the NerdWallet tool: If annual real returns are 2.5%, on average, that is, 2.5% higher than expected inflation, then the total balance can be reinterpreted. The saver put in $49,000 of their own money and, after 40 years, has a balance of $85,077.
How do you get 2.5% real today?
The longest-term TIPS bond I can find is a 30-year bond maturing in 2055, which offers a real yield of 2.58%. This is good for a low-risk investment that promises the holder cash flow adjustments when inflation is in the picture (which it always is).
The takeaway: the financial world peppers us with nominal rates. Higher expected rates have higher associated risks, and choices vary by individual. Thinking about returns in real terms is generally applicable. It’s better personal finance knowledge.
If you want a smooth line, investments need to be safe. I like how Larry Kotlikoff’s firm explains safe interest rates to its MaxiFi Planner users: “A deterministic plan intended to be used with safe assumptions answers the question: How much will I have available to spend "for sure" or with reasonable certainty?”
See Investopedia.
The smooth lines can be so misleading! I like to use the 'Random period of S&P 500 returns' option of the PFC retirement calculator to show people how volatile the stock market can be (and that doesn't even count for inflation)!