Over the next few weeks, whilst the blog is on a break, I am posting some older articles that new readers may not have gotten a chance to read. This one originally posted in November 2019.
There is not much more in the personal finance world that gets a money person (me included) drooling than compound interest.
Just the mention of those two words lights up their eyes.
If you are a regular reader you would already know about the benefits of compound interest by how much I talk about it.
But sometimes I feel I may be overstating the importance of compound interest.
By doing so, I take away the emphasis from investing your own money. What you can control.
How much you invest is far more important than your returns.
It is not always as simple as investing some money and then watching it grow. A lot comes down to luck of timing.
Often you will hear the example of Jacob. He starts investing at age 20 (yeah right!) for 40 years. At 6% returns, all Jacob needs to do is invest $120 a week to be a millionaire in 40 years.
The advice is start young, invest regularly, and you will retire wealthy with many thanks to compound interest.
If you see this advice on a table or graph you will see that the advice can be reframed as save for decades, and then in the last few years quickly double your wealth.
Compound interest over 40 years
Compound interest over 40 years
You can see at age 50, after 30 years, we have only just achieved half of what we set out to with only 10 years (one quarter)remaining.
Compound interest can fail just as you need it
The truth of the matter though is that this advice is extremely speculative. It is assuming that returns on investments happen in a straight line. The reality is that if you are seeking returns of 6% per annum, it will be far from a straight line in any given 10-year period.
Stock returns can be extremely volatile, with wild ups and downs in any given year.
We’ve basically been sold a slow and steady path to retirement that is not even based on reality.
You may get lucky and have some great returns in your last 10 years pre retirement.
But you may experience 10 years of no or minimal growth. It can and does happen. 10 years is not a long time in stock investing terms, and not long enough to always recover from large losses.
It really is nothing more than luck depending on what year you started investing. You could invest exactly the same as someone else with the only difference being they started investing in a different year, yet have completely different results.
Just when you need compounding to really kick into gear it can potentially struggle to get out of first. The markets may return 6% over the long term, but they may not deliver these returns over the short to medium term. And 10 years is short enough to be significantly affected.
Saving $120 a week as your retirement calculator told you will do little for the half a million shortfall.
Give compounding the best chance by front loading your savings
The best thing you can do is to front load your savings as much as possible, so returns in the last 10 years matter less and less because you got ahead of the curve in the first half.
Don’t rely on a number given to you by an adviser or a calculator based on averages. The order of investment returns can quite clearly have different ideas.
The worst time to have low returns is when your balance is at its highest.
Yes, compound interest can be magical if it goes in a straight line like the lovely graph. But the biggest part of the curve can disappear when we need it the most. So don’t be too reliant on compounding or your retirement plan may end up way off track.
Or at least have a more detailed retirement plan.
The information contained on this site is the opinion of the individual author(s) based on their personal opinions, observation, research, and years of experience. The information offered by this website is general education only and is not meant to be taken as individualised financial advice, legal advice, tax advice, or any other kind of advice. You can read more of my disclaimer here