The Power of Compounding Returns Is as Great as Everybody Says It Is.
I’m famous for taking a contrary view. Rob Bennett is the fellow who says that saving need not require sacrifice. Rob Bennett is the fellow who says that retirement can be accomplished in stages. Rob Bennett is the fellow who says that the stock market is not efficient. Don’t look to me to offer a contrary take on the key compounding returns question, however. Compounding is a powerful force. It’s every bit as powerful as just about all money advisors tell you it is.
It is the compounding returns phenomenon that explains the biggest mystery that newcomers to the Retire Early Movement want to have explained. Most middle-class workers are worried that they will not be able to retire at age 65. In the Financial Freedom Community, we have people pulling it off in their mid-40s. It’s not possible, is it? This falls into the Too-Good-to-be-True category, does it not?
The stuff we talk about at our boards is real. It seems unreal to many because the power of compounding returns is so counter-intuitively great. The reality is that few of us could afford retirement if we had to use money we earned with the sweat of our brow to finance it. Most of our retirements will be financed by money earned by our money. It takes about 25 years to finance a comfortable middle-class retirement. Most don’t become serious savers until age 40, so they are lucky if they can get the job done by age 65. Those who start at age 20 are able to complete the task by age 45 if they get a few breaks along the way.
Take a moment to consider what I am saying here. Those who retire at age 65 do not necessarily enjoy richer retirements than those who retire at age 45. Those who retire at 45 do not necessarily earn more or deny themselves more. They structure their Life Plans differently, that’s the thing. They frontload their saving effort. Those who retire at age 45 might not save a dime after they quit the workforce. it doesn’t matter. Retirement is attained by replacing the money you earn with money your money earns. Do that 20 years earlier and you free up 20 years of living to make use of as you please. Cool deal
That’s the power of compounding returns. Compounding returns is the real turtle soup and not the mock.
The Compounding Returns Phenomenon Applies to Spending Too.
Now we get to the part where I offer contrary views.
Most money advisors remind you regularly how important the compounding returns phenomenon is to your saving effort. Fine. I agree. They leave out a very important point. The compounding returns phenomenon applies to all money allocation decisions, not just to decisions to save. When you spend effectively, there is a compounding returns effect too.
You face a choice to spend money on a gym membership and to get in shape or to put the money in your Section 401(k) account. Most money guides suggest that the better choice is to save. This is not necessarily so. The reason why it is not necessarily so is that spending generates compounding returns too, often benefits greater than the benefits that can be obtained from saving.
Buying that gym membership might improve your health. That could end up making you hundreds of thousands of dollars richer over time. It might enhance your self-confidence, helping you to get a promotion. Again, that could put hundreds of thousands in your bank account down the road a stretch. It might help you meet the girl or boy of your dreams. That can make a big long-term financial difference; happy and settled people are generally more productive.
I urge you to begin thinking about the compounding returns phenomenon in a new light. You should not only be comparing the benefits of spending with the benefits of saving. You should also be comparing the benefits of different spending options. Some spending options generate big compounding benefits. Some do not. Move some of your money from the poor-performing categories of spending options to the strong-performing categories of spending options, and you will attain financial freedom a good number of years sooner.
Compounding Returns Apply to All Smart Money Decisions Made by the Young.
The compounding returns phenomenon isn’t a spending vs. saving thing; it is a young vs. old thing. Money decisions made when you are young have greater long-term impact than money decisions made when you are old. It’s a painfully obvious thing to say, but it needs to be said because this reality is rarely explored in the conventional literature. All money decisions have effects that extend far beyond the time-period in which they are made. Money decisions have a ripple effect. A money decision made at age 20 influences how happy you are at age 25 and 35 and 45 and 55. The younger you are when you make a money decision, the more the ripple effect applies.
I worry that these words will depress my readers of a certain age (I’m 51). “We blew it, all is lost!” we are tempted to conclude. To some extent, that is indeed true. If you are 50 and have not yet gotten serious about money, you have indeed blown a lot of exciting opportunities. Accept it. Have a good cry. Get to a point where you can laugh about it. Move on.
I’m telling you that your bad decisions have had a more powerful effect than you realized. That’s the bad side of this story. There’s a good side. The good side is that future good decisions will also have more power than you have understood they could have until you took a closer look at the power of the compounding returns phenomenon.
If you live to 90, a money decision made at 50 will have a 40-year ripple effect. You have let a lot of power to make your life the best it can be slip through your fingers by waiting until you are 50 to get your act together. But the power you have remaining to you today is greater than what most people realize they have available to them in the course of an entire lifetime. There’s lots of good stuff you can do starting at age 50. The power of compounding returns is truly immense; harness it and you can turn things to your advantage even at this late date.
You Can’t Capture the Full Power of Compounding Returns Without a Budget.
People hate budgets. With a passion. Lots of money advisors have given up trying to persuade people to keep budgets. Even a good percentage of the best savers in the world do not keep budgets. A lot of experts have concluded that people will not keep budgets no matter how many times they are told they should do so, and so it’s not worth putting forward the effort to try to persuade them.
I cannot accept this. Budgets are so powerful that I just cannot give up on my effort to persuade you to begin keeping one. It is because of this compounding returns thing that budgets are so powerful. Every money decision has ripple effects. When you make a bad choice, it hurts you far more than you intuitively expect it will. When you make a good choice, it helps you far more than you intuitively expect it will. Your budget (better referred to as a “Life Plan”) is the tool that helps you distinguish the good choices from the bad. You need a budget, friend!
Say that it takes you one hour per week to keep your budget updated. Say that keeping a budget lets you overcome paycheck dependence 10 years sooner. Is it worth it?
It’s an insane question. Everyone should have a Life Plan. You cannot achieve your potential without a Life Plan. There is no business anywhere of any size that does not keep a budget. You, Inc., needs one too.
Compounding Returns Can Kick Into Reverse.
You’re out of work for six months and you have to take $15,000 out of savings to keep up with the bills. Oh, well — it could have been worse, right?
Wait a minute — it is worse! If you take $15,000 out of savings, your loss is not just the $15,000. It’s the $15,000 plus all of the compounded returns that would have been earned by that money in years to come.
I don’t offer this thought to depress you. I put it forward because it is important that you see that compounding returns work in two directions. When you add to savings, you add more than the nominal amount of the dollars saved. Once those dollars are invested, they begin creating an income stream of their own. When you lose control over them, you lose both the dollars themselves and the income stream that they would have generated (which in the long term is likely to be a bigger loss).
Investing Losses Cause a Reverse of the Compounding Returns Phenomenon Too.
Please note the application to investing. People are far too glib about the long-term effect of stock-market losses, in my view. It’s of course true that you need to be willing to take risks to earn a good return on your money; stocks are a risky asset class but also a great asset class. But don’t underestimate the long-term effect of losses. Losing $15,000 in your stock portfolio is as bad as being out of work for six months and having to go into savings to the tune of $15,000 to cover the bills. A $15,000 loss in nominal terms looks a lot worse when you take into account the loss of compounding returns that you suffer as a consequence of that loss.
Rules of Thumb Depending on Compounding Returns Can Create a False Sense of Security.
The common rule of thumb saying that you need to save 10 percent of your income to be able to retire at age 65 presumes that you will begin saving early in life and that you will enjoy many years of compounding returns on the money put into savings in your 20s and 30s. Hearing that saving so small a percentage of income can get you to where you want to go can engender a false sense of security. If you do not begin saving when young, you fall behind each year not by the amount that you failed to put aside but by the far larger sum that is the amount that you failed to put aside plus years of compounding on that amount.
Compounding Returns Create Leverage.
The bottom-line is that compounding returns create leverage. Use this power well and financial freedom opens up to you years sooner than would otherwise be possible. Fail to take this power into account in your financial/life planning and you limit your life options in a serious way.
The idea is not to mindlessly save anymore than it is to mindlessly spend. Save in circumstances in which the compounding returns benefit is great for spending and you hurt yourself as much as you do if you spend in circumstances in which the compounding returns benefit is great for saving. Take on too little risk with your investments and you lose the compounding benefits available to those who take on more risk; take on too much risk with your investments and you lose the compounding benefits available to those who manage investment risk effectively. Compounding magnifies the good and bad effects of all money choices.
The compounding returns phenomenon truly is a powerful force. Suggestions that it is always a force for the good are misleading. You want to develop a full enough understanding of the compounding returns phenomenon to ensure that it is almost always working for you and rarely working against you.