A modest but consistent savings program combined with a prudent investment strategy can yield astounding results when allowed to grow over a long period of time. This is the power of compound growth. In the previous two articles we explained how it works and how investors can harness it to achieve their long-term financial goals. However, in an effort to attract money from investors, some in the financial services industry have exaggerated its wealth building potential by using overly optimistic return assumptions and ignoring the effects of inflation in their advertising.
As I have stated previously, the numbers investors choose to base their projections on can make an enormous difference in the projected outcome. Unfortunately much of the investment literature is filled with expectations of future returns that simply do not square with the realities of today’s investing environment. Using realistic expectations can mean the difference between arriving at retirement with sufficient assets to enjoy a comfortable lifestyle or facing a nasty surprise and having to settle for a lot less.
Let’s see what happens when we apply different return assumptions using a simple example of a 25-year-old investor who plans to retire at age 65. She wisely begins saving $10,000 per year in a balanced stock and bond portfolio and increases her contributions by 6% each year until retirement.Under the 8% nominal (before inflation) return scenario that seems to be popular in much of the industry’s promotional materials; her account balance would swell to almost $6.2 million. But in this real world of low interest rates most economists and investment analysts would question the rationale of using such lofty return projections.Economic reality would suggest that nominal expected returns of around 5% would be more accurate. At a 5% rate of return the same portfolio would grow to an impressive but substantially lower $3.4 million. Clearly it’s a lot easier to get rich when you plan on earning 8% rather than 5%. It’s tough enough however to earn 8% for just one year let alone consistently over a 40 year investing horizon.
Because we live in a world of almost certain inflation, nominal returns tell only part of the story. Even a moderate annual inflation rate of 3% takes a big bite out of the real (inflation-adjusted) wealth our investor accumulates over her 40 year career. In fact only when we adjust our growth projections for inflation do we arrive at meaningful numbers for wealth accumulation. Because of the corrosive effects of inflation, $1.0 million in 40 years will not have the same purchasing power as it does today when a loaf of bread that we can buy now for $3.00 costs $10.00. Using the example of our 25-year-old saver, the $3.4 million she would accumulate in nominal dollars at retirement is worth just over $1.0 million today. In other words, inflation reduces the purchasing power of her nest egg by two-thirds!
Compound growth can have a dramatic wealth building affect without engaging in wishful thinking and exaggerating its potential. Incorporating realistic assumptions including the expected rate of return on investments and the effects of inflation is a critical component of any long-term saving and investment plan. In the context of retirement planning, doing so will establish at the outset the expectation for how much an individual will need to save every year to achieve the lifestyle they expect. While no one can predict the future, sensible investors will err on the side of using conservative assumptions so any future surprises will more likely be pleasant ones.
