Small Differences in Rate of Return can Have Big Impacts
We financial advisors throw percentages around as if everyone understands exactly what they mean. But I suspect that most people haven’t really though through the nuance of investment returns expressed in percentages.
It is easy for most people to understand that a 9% return is “better” than a 4.5% return. But how much better? A quick and dirty mental math shortcut would assume that the higher return is twice as good. (4.5 * 2 = 9). And you would be right – if you are investing for only one year – and if you don’t consider risk. But what if you are investing for 10 years, 20, years, or 30 years? The higher return becomes more and more powerful the longer you invest, thanks to the power of compounding. Here are the numbers:
Amount Invested: $10,000
Growth at 9%
Growth at 4.5%
% similar time periods stocks lost $
Best Stock Return
Worst Stock Return
(Data taken from Dimensional Fund Advisors 2017 Matrix Book)
This table helps understand why investors favor riskier (and higher return) investments when they are saving for the long term – but maybe not for their near term needs.
Consider that the investor saving to buy a house next year might like to make a little interest on his savings. But the difference between earning the average return on stocks and 4.5% in a conservative allocation is really not that much over a single year. The reward is certainly not worth the risk when you consider that stocks lose money almost 3 years out of 10, and sometimes quite a bit! Its certainly not worth risking the loss of a big chunk of your hard earned home down payment to earn an extra $450!
But notice that as you extend further out in time, the compounded return from the stock investments starts to really add up. The parent saving for the newborns education might consider that the opportunity to see his money quintuple in value over 20 years (vs merely double in a more conservative allocation) Is well worth the risk. Especially when you consider that there has never been a historical 20 year period in which stocks actually lost money.
And as you move out farther and farther in time, the uncertainty of stock market returns grows less and less, while the VALUE of those higher earnings compounding year after year has a bigger and bigger impact.
This is why we invest and save aggressively. Next up – a look at how investment returns impact the survivability of retirement portfolios.