The False Allure of Compound Interest

by Philip Brewer on 6 March 2013 9 comments
Photo: Andrew Ciscel

You've seen compound interest stories. Just save $10 or $50 a week or a month and in 25 or 35 years you'll have a fortune! It's not so simple. (See also: Non-Financial Investments)

The compound interest story isn't wrong, exactly; it's simply misleading.

It's misleading for two big reasons. First, because things change. Second, because the huge returns from compound interest are back-loaded — they only come at the very end.

Let's start with a simple example, so we have something specific to talk about. According to my financial calculator, if you invest $218 per month at an 8% return over the course of a 35-year career, you'll end up with $500,000. Depending on your lifestyle that might or might not be enough to retire on, but it would at least be a tidy contribution to any retirement.

It's a perfectly reasonable calculation — I'm sure lots of people made that exact calculation many times during the 1990s, when people actually were achieving returns like that. I'm sure I made that exact calculation myself.

So what's wrong with it?

Things Change

First of all, you've got almost no chance of getting an 8% return for 35 years. It's possible to get an 8% return — during the 1980s and 1990s it was easy to get an 8% return. But 35 years is a long time. Things change. Over that much time you can expect interest rates to go up and down, you can expect the stock market to go up and down, you can expect inflation to go up and down, you can expect taxes to go up and down.

If you were really lucky, and started your investment program in 1981, you'll have done very well. Interest rates started out high and then declined gradually for the next 30 years. If you just bought 30 year bonds every time you had enough money to do so, you made huge gains. Except, of course, no one who started investing then would have done so. In 1981 everyone knew that bonds were trash, because we were just coming off a decade of inflation rates so high that bond investments lost huge amounts of money in real terms.

If you'd invested in stocks you'd have done even better, at least until 2001 or so. The stock market soared! In the dotcom boom, any reasonably diversified stock market investment made 20% returns for three years in a row! Except, of course, after the dotcom crash the stock market went sideways for a decade, and then in the panic of 2008 lost 40% of its value in one year.

If you were just starting to invest in 1981, you'd probably have just put your money in a money fund. After all, they were paying 14%! And they provided great inflation protection, because rates went up when inflation went up! Except, of course, when inflation went down the rates went down. Nowadays you're lucky if you can get 0.8%.

Another place you could have put your money in 1981 was gold. Gold looked pretty good right then — over the previous decade or two it had run up from $35/oz to something like $800/oz. Of course, then it proceeded to collapse and spend most of the next couple of decades at around $300/oz. Now it's back up to double its 1981 peak. For those of you keeping track at home, doubling your money in 33 years amounts to a return of just over 2%.

Finally, be aware that changes in the return on capital are really the most benign kinds of changes. Over that period of time, you also have to expect major changes in the return of capital. You have to expect that some companies will go bankrupt, leaving their stockholders with returns of zero. You have to expect that some countries will "restructure" their debt, leaving their bondholders with pennies on the dollar. You have to expect that some currencies will collapse, leaving their holders with nicely printed pieces of paper.

So that's the first problem. The period of time it takes for compound interest to start racking up those outsized returns is so long that ordinary changes are very likely to invalidate your plan.

Returns Are Back-Loaded

The other problem is that the huge returns from compound interest only really accrue at the very end.

If you stick with the program for the full 35 years, you get your half million. But suppose things go awry. Suppose you have to quit after just 15 years. That's still a chunk of time, right? I mean, it's almost halfway, right?

It may be almost halfway, but that does not mean you get almost half the money. In fact, after 15 years all you're going to have is $75,000. That's a pretty small fraction of your half million.

In fact, even if you stick it out for 25 years, you're only going to have $207,000, well under half your goal, even though you've stuck to your savings plan for more than two-thirds of the total time.

This back loading doesn't just make your result terribly sensitive to ending your contributions early, it also makes your result terribly sensitive to the terminal interest rate.

Suppose you stick out the whole 35 years, making every payment exactly as planned. Suppose further that you manage to achieve your planned 8% return for the first 30 years, but your average return over the last five years is only 1%. How much difference does that make? It takes your total return down from half a million down to just $355,000.

So that's the second problem. It turns out that it's not good enough to get a good average return over the whole period; unless you get a good return over the last few years, your compound return ends up being crappy.

None of this is to say that compound interest can't work for you — it can. Save and invest — and keep an eye on your investments, on the markets, and on the investment climate generally — and you can probably expect to make good returns over the long-term. Just be very careful about buying into the story of compound returns too literally.

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Guest's picture

The idea of earning 8% annually in the stock market is looking at what it has dome over time. Yes, there will be years when you only earn a 1% return or lose 10%, but over time, the market averages out to be 8%. This also has nothing to do with interest rates. The market may drop or jump when the Federal Reserve announces it's plans for interest rates, but the stock market and interest rates are two different things.

I do agree that you need to see the investment through to realize your goal with compound interest, but I take the opposite viewpoint: I'd rather save for 15 years and end up with some interest rather then leave the money in a savings account earning nothing. In that scenario, I most likely have less money since inflation has been eating away the value of my money.

Philip Brewer's picture

I absolutely agree that investing in the stock market is a good choice, for the money that you can safely commit for the long term. I've written about exactly that, such as this post on why stock market investing makes sense:

http://www.wisebread.com/why-invest-in-the-stock-market

My objection is not to the idea of making long-term investments, my objection is to latching onto that 8% average return and then saying, "Hey! That's how much money I'll make!" The fact that stock market returns have averaged something over the recent past does not mean that they'll continue to average that—as I would think the experience of the recent twenty-odd years would convince anyone.

There's no guarantee that we'll hit the average. Worse, as I tried to say in this article, it also makes a difference exactly when the gains come. One might say that returns "averaged" 8% if they were 9.4% for 35 years and then -40% for one year. If that year with the -40% was the first year you were investing, it would scarcely matter. But if that year was the year before you planned to retire, you'd end up with a third less than you'd bargained for.

Do save. Do invest. Just don't imagine that "average" returns have a lot to say with how much money you'll end up with.

Guest's picture
KDB

Well, it might be true that huge returns are on the back end. But if you don't get started, there never is a back end, right? I don't think anyone (with any money sense) is portraying compound interest as some type of "get rich quick" investment principle.

And if not compound interest, then what? Bonds? Money markets? Stocks? The first two offer little hope these days, and the last is super risky.

Philip Brewer's picture

What you want is a diversified investment portfolio, with investments selected to match the time horizons of your various goals. I talk some about how to do that in this post:

http://www.wisebread.com/best-asset-allocation-for-your-portfolio

I'm not saying "don't invest." I'm saying, "Don't expect a financial calculator to predict the future." Even if you have very accurate historical data to feed it, your financial calculator isn't up to that task.

Guest's picture
Todd

"First of all, you've got almost no chance of getting an 8% return for 35 years."

Oh, 8% long-term annual portfolio returns are definitely achievable. If you invest mostly in stock market index funds when you're young and shift into a more balanced portfolio as you approach retirement, you could get there.

First, let's examine the historical returns on stocks. From 1871 through 2012, the stock market had an arithmetic mean of 10.6% per year and a geometric mean of 8.9%. While the annual standard deviation of returns on stocks is large, the long term returns are remarkably consistent:

Over the last 50 years (since 1962), it has averaged 10.9% (arithmetic) and 9.4% (geometric).
Over the last 40 years (since 1972), it has averaged 11.6% (arithmetic) and 10.0% (geometric).
Over the last 30 years (since 1982), it has averaged 12.6% (arithmetic) and 11.2% (geometric).
Over the last 20 years (since 1992), it has averaged 9.9% (arithmetic) and 8.2% (geometric).

And while annual declines of 40% in the stock market can happen, as long as you stay fully invested over the long run, you should still do well. Notice how just 4.5 years after the crash in the fall of 2008, we're already at new all-time highs in the stock market.

"The other problem is that the huge returns from compound interest only really accrue at the very end."

Yes, the benefits of compound interest are largely "back loaded", so those returns in the years leading up to retirement are important. But unless you're 100% invested in stocks right before retirement and planning to use ALL of your retirement money the year you retire, you should do fine. A diversified portfolio of stocks, bonds, REITs and commodities could achieve returns close to 8% per year with significantly less volatility than an all-stock portfolio.

The one thing you didn't mention in your article that would've greatly supported your case is that many people don't factor INFLATION into the equation. And that's where compound interest can be a little misleading. 8% nominal returns are certainly attainable, but 8% real (inflation-adjusted) returns would be much more difficult to achieve. Although I think you could still get close.

Compound interest can certainly work for you, like it has for so many others. And the greatest thing I've learned from it is this:

The earlier you start saving and investing, the better.

And there's no false allure in that.

Guest's picture
Ibcuser

Very good article and great arguments. So what can you do? What if you look at records of 100 years of so of the insurance industry in particular Whole life insurance.
Many insurance companies have weather all kind of changes in economy and provided stable growth. We are life time consumers, when you add to the stability of a Life Insurance Company, a paradigm change where you use the capital you are growing to finance your needs, you can improve things.
Even in low interest periods financial institutions are going to collect above average interest from you when you take loans from them, so why not switch and pay that above average interest to your own policy when financing.
Doing that simple change gives you control to improve the return on your capital.

Guest's picture
Lou

This is why I always use a 5% average return in my forward calculations - plan around more conservative predictions and anything more is a bonus.

I use roughly 50/50 term deposit cash accounts which tend to yield 4-5 per cent and blue chip stocks which fluctuate bit but return about 3-5% on dividends alone. I'm risk averse so hopefully that's a reasonable balance of growth prospects and security.

Guest's picture
average joe

A lot of people commenting on the article are completely right. But they also seem very educated in finance matters.
This article is helpful by pointing out one of the very likely flip sides of the savings + compound interest magic pill that is aggressively fed to your average joes with minimal finance knowledge.

Guest's picture
Robert

One flaw in the discussion of gold as an investment is that you assume the value of gold should be measured in dollars, but dollars have a fluctuating purchasing power. In fact, they have lost 97% of their purchasing power since 1971, while gold during the same time frame has significantly increased its purchasing power with respect to real goods and services.