Comments on: The false promise of compound interest A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 By: Galician Wed, 23 Mar 2011 03:29:00 +0000 Discussion regarding compound interest is only really relevant with respect to credit, in which case, the promise of compounding interest is not false.

For most people, the largest percentage of their wealth is tied up in their home. And, for most people, they have a significant mortgage to match. Compared to equity markets, interest rates are stable. Net wealth can be increased by reducing debt while holding savings constant. Accordingly, paying a mortgage is saving. Gains are made not in extra earnings but reduced interest expenses by paying down the loan early. Most people are more likely to achieve this through the discipline of regular repayment. Fail to make payments and the power of compound interest will wipe you out.

Simplistically speaking, when it comes to establishing strategies for building up wealth in equity markets, dollar cost averaging is a more useful concept.

By: wpfau Tue, 22 Feb 2011 05:32:33 +0000 TFF: Thank you for the comments. You did indeed find a typo! I’m out of my office, so I’m not sure of the precise correction, but I will fix this as soon as possible. Thank you.

Regarding your concerns about lower future returns, I am completely on board with you. I discuss this some in the section, “Potential Tragic Consequences of the Traditional Retirement Planning Approach” on page 12.

Another paper I’ve written which explores this concern is:

“An International Perspective on Safe Withdrawal Rates: The Demise of the 4 Percent Rule?” ue/TableofContents/AnInternationalPerspe ctiveonSafeWithdrawalRates/

As the U.S. enjoyed an amazing century for asset returns relative to most of the other 16 developed market countries in the dataset I explore.

Thank you again! Wade

By: TFF Sat, 19 Feb 2011 15:12:05 +0000 wpfau, your article on the “safe savings rate” is very interesting and makes a ton of sense. Put another way, the S&P500 has doubled over the past two years (and thus account balances have gone up). Is an investor aiming to fund retirement twice as wealthy today as she was two years ago? Past returns and forward returns move in opposite directions.

(I believe there may be some typos in the table on page 15? Duplication of numbers in the 70% replacement rate section… But that is a minor issue.)

My greatest concern is that the next fifty years might be weaker than the last century. It may seem like you are dealing with a large amount of data, however you are looking at ~60 year slices of a single century. They are clearly not independent of each other, which begs the question, “What if the US economy faces greater challenges in the 21st century than it did during the 20th century?”

You suggest that a 30 year flat-contribution savings period requires a 16%-17% savings rate (50% replacement for a 30 year retirement). But if long-term growth is weaker, the required savings rate will be much higher. Felix regularly worries about zero real returns — and while I believe he exaggerates this concern, my own estimates suggest they will average in the 2% to 3% range for the portfolio you study. Is that enough to float this boat?

By: wpfau Sat, 19 Feb 2011 11:03:22 +0000 Felix, Thank you for the interesting article.

May I direct you to two research articles I’ve written which I think are relevant to this topic?

Forthcoming in the Journal of Portfolio Management (Fall 2011) is an article about the “portfolio size” effect, which indicates how vitally important the last decade before retirement is. To understand this, just consider the portfolio growing at a constant percent growth rate. It may be $1 million, at retirement, but 10 years earlier it might still only be around 400k. If you experience a bad decade just before retirement, well that is a big problem. 1.html

Second, I just finished an article this month about the “safe savings rate”, which is the lowest savings rate from rolling historical periods that would have provided you with enough wealth at retirement to finance your planned retirement expenditures. There is not a universal safe savings rate, it needs to be calculated for a person based on their life circumstances. But in this framework, if you are following the safe savings rate, then the actual wealth accumulations and retirment withdrawal rates become less important. 6.html

Thank you.

By: lexus Sat, 19 Feb 2011 03:34:49 +0000 As luck would have it, never having had to bear excessive healthcare burdens, being still happily married after 44 years, not having to raise kids until I was in my 40’s, and having been blessed with the ambition to work my way through an excellent technical education without incurring debt, I now approach my 80th year in pretty good financial shape.

But I never paid much attention to financial planning. I have a deep mistrust of money, financial markets, and the calculations of economists and planners. Such calculations only work in a predictable economic and political world, which we in the U.S. have enjoyed from 1946 through century’s end, but which looks more and more like it may terminate soon.

Instead, from about age 30 on I decided to follow the strategy of my European ancestors, who believed that value is in land, not money. I first bought a livable house at a cheap price (away from congestion) outside a growing city. Instead of a savings account I paid down the mortgage; the idea was to acquire equity in real estate. I enjoyed my job as an engineer but never saw it as a road to riches and never intended to stay with any single employer, moving “up the ladder”. As I moved to better jobs in more prosperous areas I followed the same strategy of buying bargain (but livable) homes in good areas and keeping the mortgage low.

My final house investment, in middle age, was in a semi-rural area outside a massive metropolis where I could buy a 1-acre lot with a brand new 3-bedroom house for the princely sum of $80,000. There was not much else besides a gorgeous view of 8,000-foot mountains, access to a private water company, and decent soil for planting lots of trees and potentially a productive garden.

Since my savings plan didn’t involve saving cash, worrying about rates of return, or playing the markets, I was’nt concerned about the size of my income as long as I could provide comfortably for the family and pay down the mortgage, so I took whatever employment I could get in the new location, which turned out to be straight-commission real estate sales.

This proved interesting enough and a relief from engineering drugery, and as time went on I learned how to work profitably for myself instead of under a boss’s thumb. I also ran into opportunities to buy rental units for practically zero investment. Although I never earned over net $40,000/year in my life (thus keeping me out of high tax brackets) I built up a significant retirement nest egg in the form of rental properties with very low mortgages that now bring in a steady income which can keep up with inflation. .

I still live on the same 1-acre property which now has a 1/3 acre private park (80 foot pine and oak trees) and a rental guest house whose income pays for landscaping upkeep, utilities, taxes and insurance. I have effectively no mortgage and pay very low property tax on the original 32-year old value, giving me a positive cash flow on my home! The neighborhood has matured, and because it’s in the foothills away from traffic, is now dotted with custom-built mansions appraising (even today) at over 1 and 2 million $. I still work, mostly on the property, but also at my part-time computer consulting business, not because I have to, but because it keeps me from aging more rapidly physically and mentally.

All of this is NOT meant as a brag, and obviously not as a strategy suitable for everyone, but rather as description of an alternative to prevailing American career practices, such as: attempting to climb the employment ladder with it’s inevitable psychological stresses that slowly kill (high blood pressure, obesity, etc); attempting to save dollars in bank accounts or in dollar-denominated investments which you can’t possibly control because you are too busy; and ending up with a huge mortgage, car payments, the inevitable credit-card nightmare, and spoiled kids.

The foregoing destructive practices were promoted largely by leaders of the Baby Boomer generation. Few Americans lived that way before WWII (many couldn’t even if they had wanted to). Apparently later generations haven’t learned the lesson yet.

I don’t pretend to know all the answers, but if any young person is looking for an opinion, here it is: don’t avoid financial markets, but approach them only with great caution; instead, invest primarily in things that can’t suddenly disappear but can produce reliable income on their own, like well-located land (with low debt) or a recession-proof business or profession; and don’t be afraid to strike out on your own rather than tie yourself permanently to somebody else’s enterprise.

Of course, if you happen to be very very smart, a talented politician, supremely ambitious, and not too ethical, you may freely disregard this advice and get rich quickly.

By: TFF Sat, 19 Feb 2011 02:57:18 +0000 On the contrary, FifthDecade, we’re all in this together. The savers will pay the most, because they’ll have the most to spare. But what is the alternative? Not saving isn’t going to improve the situation either personally or for the nation as a whole.

There may also be a counter-trend benefit to saving when others are spending. The economic boom that has done nice things for investment accounts over the last 25 years was fueled by debt.

By: FifthDecade Sat, 19 Feb 2011 02:28:39 +0000 So, nobody thinks debt is a problem for savers? Nobody thinks it hurts the economy or fuels inflation?

By: TFF Fri, 18 Feb 2011 15:18:42 +0000 “The standard of living for working Americans is falling in real terms.”

Absolutely agreed, and this is what worries me the most. The Baby Boomers were born, grew, and worked during a 50 year economic boom, extending from the end of World War II (when the US was the only major economy in the world not destroyed by the fighting) through the technological innovation of the 80s and 90s.

I have not yet had a chance to read Rajan’s book (not about to spend $20 on a copy for myself, and the library copies have been on continuous hold), but from what I gather he makes some excellent points. The US economy was showing some serious cracks in the late 90s, and without extensive borrowing to prop things up might have taken a pretty hard landing during the bursting of the dot-com bubble.

But now where do we stand? Not only did the economy not crash between 2000 and 2007, it wasn’t even permitted to EASE substantially. So the inevitable correction remains in our future — less whatever setbacks we’ve adjusted to over the last three years.

Economic systems are a somewhat-artificial convention, designed to direct the production and consumption of goods and services. We know that somebody will end up seriously bloodied as the imbalances are forcefully corrected, but the total damage done depends on our ability to improve productivity while the distribution of the damage depends on political choices. Unfortunately those elements are in somewhat of a tension, with the “compassionate” political choices likely resulting in lower growth while the “business friendly” political choices leave much to be desired socially.

By: TFF Fri, 18 Feb 2011 12:41:15 +0000 Strych09, read back to the original article and you’ll see the rather outrageous line, “But of course nobody does that. […] Well, maybe those of us who go on to become investment bankers.” I definitely overreacted in response, but “nobody does that” is a pretty strong statement and “of course” doesn’t in any way soften it.

najdorf, we’ve never had a SINGLE job paying more than $70k. The total AGI through our 30s was never more than $100k (and that figure is boosted by working weekend jobs). You can make a strong case that a household income of $90k-$100k with two kids is “wealthy”. I agree. But no matter HOW much you earn there is always somebody wealthier than you and always somebody less well off. If you pattern your lifestyle after those who are one step less well off, then you can find savings. Likewise, if you pattern your lifestyle after somebody who is one step wealthier, you will end up deeply buried in debt.

I very much understand that circumstances and luck differ. My students do not come from privileged backgrounds, so I see and work with this daily. Student loans are a terrible burden, especially because (with the time value of money) they are incurred so early in life. Just last week I proposed greater funding for the public universities for the express purpose of REDUCING the student loan burden on our youth. Give them a quality, fully-funded alternative to the private colleges.

Finally, virtue is described by one’s actions in life, not by one’s bank account. I’m not sure why people are confusing the two. Failing to plan for your future is short-sighted, since I fear the social safety nets of this country are about to be shredded, but it isn’t sinful.

By: najdorf Fri, 18 Feb 2011 07:19:11 +0000 TFF: DINKs making $70k/year each are pretty wealthy. Some people can’t make that much. Some people have kids sooner (you could attribute this to stupidity or you could attribute it to concerns about infertility/making disabled kids by waiting). Some people have careers that are derailed by kids. Some people don’t find a compatible partner that young. Some people get sick, get divorced, or lose jobs. Sorry, your luck is a lot more significant to your current position than your virtue.