The Myth of "Compounded Returns"
There is no evidence that Albert Einstein ever declared compound interest to be “the most powerful force in the universe.” This article will point out the danger in relying on compounding as the basis for projecting your investment performance. This myth is propagated by the large investment houses that want you to believe that retirement planning should be based on buying and selling mutual funds with the click of a mouse and collecting fees to manage those mutual funds plus collect $7.95 or more every time you click.
Before we continue, consider the credibility of the following quote: “Don’t believe everything you read on the internet – Abraham Lincoln”. That means that you shouldn’t believe the conclusions in this article just because I am a scientist who wrote it. What you need to do is follow the logic presented here and only if you don’t see a flaw in the logic, then you can adopt the conclusions suggested.
As always, I am not giving investment advice in this article. I am sharing my perceptions and experiences in the real world, supported by data, that have led me to invest in a diversified portfolio of investments, including, but not limited to, rental real estate bought at a large discount to market value then renovating and renting the property to generate reliable positive cash flow during varying market cycles.
Let’s start with conventional wisdom promoted by the big brokerage houses. I have a portfolio of mutual funds with one of the well known big investment firms. I “invest” in the stock market to diversify my investments, not because I expect great results. In fact, I consider the stock market to be unpredictable and the periodic downturns kill any ability to rely on predictions or planning. I park some money in the stock market to avoid having too many eggs in one basket, even the real estate basket that is much more predictable than many perceive as long as you buy real estate well below market value.
My brokerage house recently sent me a brochure about retirement that assumes an 8% growth per year of a well designed diversified portfolio of mutual funds. We will use this 8% number in the analysis below in a few minutes.
Of course, since I always challenge all underlying assumptions to make sure they pass the smell test, I went to their website to see how they justify with hard data the 8% per year growth number. I found that they gave historical returns for four portfolios based on risk tolerance and they are: 5.89% for “conservative,” 7.83% for “balanced,” 8.80% for “growth” and 9.47% for “aggressive.” Since most people go with a “balanced” or “growth” strategy, 8% per year sounds reasonable according to these data.
Then I read the fine print that is literally written in a barely readable 6-point font at the bottom of the table written in 12-14 point font. It shows that the data source covers the period 1926 to 2018. I guess they started in 1926 because they didn’t have data back to Methuselah.
For the purposes of this article, I will consider a 20-year investment horizon since that should be a long enough period of time to smooth out market fluctuations while still being practical for most people from my kids in their 30’s to me in my 60’s.
The compelling case for compounding is well illustrated by focusing on the blue line in the figure. The blue line shows that if you invested $100,000 and it grew at a compounded rate of 8% per year, you would have an impressive $466,095 after 20 years.
The big brokerage houses would like to stop this article right here and not proceed further with any analysis since most people don’t like math. All the stock broker has to do is misleadingly state with authority that the smartest man in human history who invented the theory of relativity said that “compound interest is the eight wonder of the world,” then put a disclaimer that “past performance is no guarantee of future results” and the job of this licensed advisor gets distilled down to asking you if you want to go conservative, balanced, growth or aggressive.
I hope you chuckled when you read the last paragraph because that could be verbatim what you heard if you ever sat in the office of a stock broker after waiting in their marble floored waiting room for 5 minutes before being escorted into the inner sanctum of the brokerage.
Of course, you are smarter than that. If you weren’t smart, you wouldn’t be reading my blog. Yes, critical thinking and due diligence are necessary prerequisites to earning a spot in my sphere of influence.
Being as smart as you are, you know that markets NEVER behave smoothly. In case you haven’t yet had a cup of coffee, let’s consider reality slowly by assuming that sometime during the 20-year run of perfect 8% compounded growth, there will be one hiccup in which the market will DROP by 8%.
The red line in the graph (partially obscured by the green line), shows what would happen to your $100,000 if you had 19 perfect years of 8.0% per year growth and 1 single lousy year of 8.0% decline in Year 5. After 20 years, you would wind up with $397,044.
Wow…due to the “magic” of compounding that one drop of 8% resulted in a 15% reduction of overall performance. Yes, compounding works both ways.
If you were planning to withdraw $300 per month from this nest egg during retirement, that one-time 8% drop (1 in 20 years) robbed you of 230 months (nearly 20 years) of distributions.
But wait…there’s more! Let’s throw one more curve ball and add a second 8% drop in Year 10. In other words, we will have 18 perfect years of 8.0% per year gain and 2 years of 8.0% drop in Years 5 and 10. That’s the green line. At the end of 20 years, your initial $100,000 becomes $338,223. That is a whopping whopping $ $127,873 less than your planned $466,095! Imagine your surprise when you run out of money at an age at which you would have a hard time finding a well paying job.
But wait…there’s more! The black line represents the past 20 full years of actual growth of the S&P 500 from 1999 to 2018. The best year had a super duper gain of 29.6% in 2013 (that was 50% bigger than the “Trump Bump” of 2017). The worst year was 2008 (the last year of the Bush administration) with a mind-boggling loss of 38.5%.
Wow…reality is a lot more complicated than assuming an 8.0% per year compounded return over a 20-year period.
In fact, someone who invested $100,000 in the S&P 500 Index in 1999 would have had $203,960 at the end of 2018. That is LESS THAN HALF OF THE PROJECTION BASED ON 8% COMPOUNDED RETURN!
Are you planning your retirement based on "magic of compounded returns" sold to you by an investment house? Do you accept as sacred the graphs shown by IRA companies (traditional or self-directed) that show what happens to your pre-tax returns at some fixed compounded annual rate?
Those graphs simply do not reflect reality!
Even when you engage in flipping houses, buying discounted notes or other investments with high returns, don’t fool yourself into thinking that your yields are as humongous as your annualized ROI’s unless you redeploy every penny earned immediately (next day) into the next deal at the same ROI. I have seen sophisticated investors make this simple mistake.
You need to learn about the characteristics of the different investment vehicles available.
Save the date November 19, 2019 to hear me speak at South Jersey REIA on the topic “35 Lessons I learned in 35 Years of Part-Time Investing.” I will cover strategic planning, enjoying your occupation, improving performance for rentals, flipping, wholesaling, lease-option, stock market, precious metals, private equity, private lending, leverage of OPM, relationships, self-image, the “perseverance myth,” the “pre-tax savings myth,” the “compounding myth,” how to deal with so-called experts and authority figures (including myself!) and many other hard hitting bullet points that will make you think deep and wide. You cannot miss this presentation unless you already live a perfect life.
If you’re really smart and willing to invest in yourself and your future, now buy the Smarter Investing Home Study Course in which I teach how to achieve full-time income through part-time investing like I did.
Of course, the alternative is that you can continue to accept the oversimplification of the compounded return at a fixed growth rate and pray that your world of finances will be perfect going forward.
My 1-on-1 coaching schedule in fully booked for June and July (2019), so if you want to apply my strategic thought processes to your situation, contact me for available dates in August or September (2019).