Posts tagged ‘compounding’
Filet or Mac & Cheese? Investing for Retirement
The financial crisis of 2008-2009 placed a large swath of investors into paralysis based on a fear the United States and the rest of the world was on the verge of irreversible destruction. Regardless of what the newspaper headlines are reading and television pundits are spouting, individuals have to shrewdly plan for retirement no matter what the economy is doing. So then the question becomes, do you want to be eating macaroni & cheese in retirement, or does filet mignon or alternate five-star cuisine sound more appealing? I vote for the latter.
Despite what the government statistics are saying about the current state of benign inflation, you do not need to be a genius to see medical costs are exploding, energy charges have skyrocketed, and even more innocuous items such as movie ticket prices continue to rise. If that’s not a burden enough, depending on your age, there’s a legitimate concern the Social Security and Medicare safety nets may not be there for you in retirement. It is more important than ever to take control of your financial future by investing your money in a more efficient manner (see Fusion), focusing on long-term, low-cost, tax-efficient strategies. Whatever the direction of the financial markets (up, down, or sideways), if you don’t wisely invest your money, you will run the risk of working as a Wal-Mart (WMT) greeter into your 80s and relegated to eating mac & cheese (for lunch and dinner).
Broaden Your Horizons
The last decade has been tough for domestic equities. It’s true that not a lot of compounding of returns has occurred in the domestic equity markets over the last decade (see Lost Decade), but that weakness is not necessarily representative of the next decade’s performance or the past relative strength seen in areas like emerging markets, materials and certain fixed income markets. These alternatives, including cash, would have added significant diversification benefits to investor portfolios during previous years. Rather than focusing on what’s best for the investor, so much financial industry attention has been placed on high cost, high fee, high commission domestic stock funds or insurance-based products. Due to many inherent conflicts of interest, many individual investors have lost sight of other more attractive opportunities, like exchange traded funds, international strategies, and fixed-income investment vehicles.
Rule of 72
Depending on your risk profile, objectives and constraints, the “Rule of 72” implies your retirement portfolio should double from a $100,000 investment now to roughly $200,000 in seven years (to $400,000 in 14 years, $800,000 in 21 years, etc.), assuming your portfolio can earn a 10% annual return. Unfortunately, this snowballing effect of money growth does not work if you are paying out significant chunks of your returns to aggressive brokers and salespeople in the forms of high commissions, fees, and taxes (see a Penny Saved is Billions Earned). For example, if you are paying out total annual expenses of 2-3% to a broker, advisor, or investment manager, the doubling effect of the Rule of 72 will be stretched out to 9-10 years (rather than the above mentioned seven years). If you do not know what you are paying in fees and expenses (like the majority of people), then do yourself a favor and educate yourself about the fee structures and tax strategies utilized in your investments (see also Investor Confusion). If you haven’t started investing, or you are shoveling out a lot of money in fees, expenses, and taxes, then you should reconsider your current investment stretegy. Otherwise, you may just want to begin stockpiling a lot of macaroni & cheese in your retirement pantry.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and shares in WMT, but at the time of publishing SCM had no direct positions in any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on the IC “Contact” page for more information.
Compounding: A Penny Saved is Billions Earned
What is “compounding” and why is it so great? It sounds like such a fancy financial term. One can think of compounding as a snowball rolling down a hill – the longer the snowball rolls (or the higher up the mountain you begin), the more compounding will expand the size of your snowball. Expanding your investment portfolio through compounding should be your major goal.
Albert Einstein, arguably one of the most intelligent people to walk this planet, was asked to describe mankind’s greatest discovery. His answer: “compound interest.” He went so far as to call it one of the “Eight Wonders of the World.” The benefits of compounding can be demonstrated via famous explorer, Christopher Columbus.
We all know the story, “In 1492, Christopher Columbus sailed the ocean blue.” To emphasize the benefits of compounding, let us suppose that Christopher Columbus made an investment in the historic year of 1492. If Chris had placed a single penny in a 6% interest-bearing account and instructed someone to remove the interest every year and put it in a piggybank, the total value collected in that piggybank would eventually accumulate to more than 30 cents. A pretty nice multiplier-effect on one penny, but not too much absolute cold hard cash to write home about…agreed?
"It's magic, I can turn pennies into billions."
However, if the young explorer had placed the same paltry investment of one cent into the same interest-bearing account, but LEFT the remaining earned interest to compound (thereby earning interest upon the previously earned interest) the results would be drastically different.
What would you guess the compounded account would be worth in 2009?
$10,000? $100,000? $1 million? $10 million? $100 million?
“NO” is the correct answer to all these guesses.
The correct answer: $121,096,709,346.21! Your eyes do not deceive you. That one penny invested in 1492 would have grown to $121 billion dollars today. If you don’t believe me, pull out your calculator and multiply $.01 * 1.06%, and repeat 517 times. Surely, we will not live 517 years to collect on an investment of such long duration. However, with proper planning everyone has the ability to invest quite a bit more than one cent to significantly build future wealth.
As an advisor, the problems related to compounding I see investors commit most are two-fold:
1) Investors are constantly shifting money in and out of their accounts (usually at suboptimal points) due to apprehension and greed, thereby nullifying the benefits of compounding.
2) Because of overpowering fear relating to current economic conditions, investors are parking their money in low yielding CDs (Certificates of Deposit), savings accounts, checking accounts, money market accounts, or other low returning investment vehicles. This strategy is equivalent to pushing the aforementioned snowball over the sidewalk, rather than down a long, steep hill.
In order to reap the rewards of compounding and dramatically expand your investment portfolio, a systematic, disciplined approach to investing needs to be followed. A system that more likely than not has a 20 year horizon rather than 20 days. Now go start saving those pennies!
Investing Caffeine 
