Introduction

The secret to getting rich slowly but surely is through compound interest.1

Compounding

Compound interest means that you earn interest not only on the principle of a loan or investment but also interest on all accumulated interest. Consider 10% interest on a $1,000 investment. At the end of year one, your total amount would be $1,100. At the end of year 5, you would have $1,611. After ten years at 10% interest, if you hadn’t withdrawn your investment, you would have $2,594.

The Rule of 72 is a shortcut calculation for exponential growth. It shows how you can transform your savings into a fortune, given enough time. To calculate how many years that it will take for your investment to double in value, divide 72 by the annual rate of return. For example, a portfolio with an annual return of 8% will double every 9 years. Similarly, if the annual rate of return is 9%, then the portfolio will double every 8 years.

The Rule of 72 suggests that a $50,000 initial investment would grow to a $1,600,000 investment in 45 years at 8% growth. And, it would only take 40 years at 9% growth. Clearly, even a single percentage point over the long term makes a big difference in the number of years that it takes for you to accumulate your target retirement funds. As the table below shows, exponential growth is actually a bit faster than the Rule of 72 shortcut suggests.2

Compounding is why Malkiel and Ellis say that “time is much more important than timing.” Rather than trying to time the market, it is far more important for you to create a personal habit of saving regularly, starting early in life. The longer that you save, the more accumulated interest that you will compound. This is particularly true if you use a tax-deferred account for your savings, such as a 401(k).

Compounding also explains why high-interest loans and credit card debt are so bad. Assume for a moment that your credit card charges 18% interest. The Rule of 72 shows that you would owe double your original amount to the credit card company in just four years!3

Inflation & “Real Returns”

What is most important is not the dollar amount but the purchasing power of the money that you save. In other words,  what your savings will buy when you retire. Expect inflation to destroy the purchasing power of your savings almost as fast as you build wealth, depending on your asset allocation. If your investment strategy is too conservative (e.g. an income-only portfolio), then inflation will compel you to spend not just interest on your savings but also the principal.

Depending on your asset allocation, your long-term investment return will likely be around 5% before adjusting for inflation (nominal rate of return). Adjusting for inflation (currently around 2%), then you will have a 3% real return.

Consider:

• At a 2% rate of inflation, the purchasing power of your savings will be cut in half every 24 years.
• At a 3% rate of inflation, the purchasing power of your savings will be cut in half every 18 years.
• At a 4% rate of inflation, the purchasing power of your savings will be cut in half every 14 years!

Over the long-term, before inflation, expect the following average nominal returns:

• Stocks: 8.7%
• Bonds: 3.5%
• T-bills: 3.25%

Over the long-term, after adjusting for inflation, expect the following average real returns:

• Stocks: 6.7%
• Bonds: 1.5%
• T-bills: 1.25%

Investment returns are covered in greater detail, here.

Summary

Coming soon!

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Updated on January 5th, 2019