Saturday, April 9, 2016

The Power of Compound Interest

In 1790, Ben Franklin's will left £1,000 (then $4,400) each to the cities of Boston and Philadelphia, to be invested and not withdrawn from until 100 and 200 years later. By 1990, after 200 years, the combined value of the investments had grown to over $4.5 million.

The power of compound interest is no secret, but those articles are missing the point. They do a great job demonstrating how compound interest works and showing you a pretty bar graph, but what they fail to do is inform you as an investor trying to make career, portfolio, and retirement decisions.

So, how can you use your newfound knowledge of compound interest to work for you? Let's consider John, who starts his career at 22 making $50,000 per year and plans to retire by age 62.

To plan for retirement, John has done some math. Every year, he is hoping to get 3% raises (finishing his career making over $160,000), plans to save 5% of his salary in a 401(k), and make a 9% return on his investment in a S&P 500 index fund.

If he does that, he'll end up with $1.17M when he turns 62. Using the 4% rule (which has recently come under more scrutiny, but is still a good starting point), John should be able to safely withdrawal $47,000 per year for the next 30 years without running out of money. Maybe that's enough for John, but more likely it's not. If he doesn't like the idea of going from $160,000 salary at age 62 to living off $47,000 he needs to increase his nest egg. But how?

Well, he could earn more money. Let's assume he works his way up the ladder, earning 5% raises every year on average, ending his career at $350,000 as the CEO of his company. The other factors remaining the same (5% savings rate and 9% returns), his portfolio would be worth $1.52M at age 62, good for $61,000 per year. That isn't a huge increase, and most people can't bet on climbing up to a salary $350,000 per year.

This graph shows how John's portfolio value at retirement changes as he gets bigger raises. This data set (and each one to follow) is a single variable sensitivity analysis: the other two variables (savings % and return %) remain the same (5% and 9%).



Or, he could save more. If he doubled his savings rate to 10% (3% raises and 9% returns), he would double his nest egg to $2.34M, or $93,800 per year using the 4% rule. Now that's starting to sound pretty good. But for some people, scrimping your whole life just to have more money when you're old isn't super appealing. Or maybe you're a saver, but are looking for other ways to make sure you'll have more than enough. Or maybe you want to retire early.

As described above, for the annual raise % series of the chart, only annual raise % changes and the savings % and return % stay at the base percentages (5% and 9%). For the savings % series, only the savings % changes and the raise % and return % stay the same (3% and 9%).



The last leg in this three-legged stool of your nest egg is return. If you can squeeze another 3% out of your portfolio return (for a total of 12%, with 3% raises and 5% savings rate), your nest egg at age 62 jumps to $2.49M, more than doubling your savings rate got you. Push that 3% more to 15%, and you have $5.51M at 62 or $2M at age 55. Now you can truly appreciate the genius of Ben Franklin.


Not only is your effort better spent increasing your returns, but increasing your return will lower your retirement age.



We already discussed that anything above 5% raises is pretty unrealistic, and although increasing savings is beneficial it might not be the easiest or most enjoyable path to retirement. So how realistic are long-term returns of 12-15%+ (while still being able to sleep at night)? That's the subject of another post.