There is an old article from 2010 that keeps making the rounds onto my facebook feed. It’s written by Dave at DaveRamsey.com, it’s called “How Teens Can Become Millionaires“, and the basic summary is this:
- Ben invests $2,000 per year between the ages of 19 and 26.
- Arthur invests $2,000 per year from the age of 27 until he retires at 65.
- Both guys earn a 12% return on their money.
- Ben has saved a total of $16,000, while Arthur has saved a total of $78,000.
- But Ben is worth a lot more by the end.
- This table:
Conclusion: don’t underestimate the power of compound interest, start early.
- I agree, in principle, that we underestimate the power of compounding.
- Except that I think this story is deeply deeply wrong. To the point of feeling ill.
- And it’s terrible economics.
- Also – where are the teenagers?
The Terrible Economics
So by far the biggest issue that I have is that Dave’s story implies that money somehow has its own value. As in: people can earn 12% per year, year on year, for years – but what you can buy with $2,000 at age 19 is what you can buy with $2,000 in 30 or 40 years’ time.
If everyone is earning that 12% return, then it means that people will have more money. But having more money does not mean that people will be wealthier – it more often means that prices will go up. So unless that return of 12% comes from real increases in productivity (like trees that make 12% more apples every year, or mines that produce 12% more gold every year – which is almost impossible over the period of time that we’re talking about), then prices will be going up at a similar rate.
So you can’t look at this as “money” alone. You have to look at this in terms of “purchasing power”. And I’m going to start by saying that, when Ben starts investing at age 19, the price of a nice meal for 2 people is around $50. And that the price of the meal will keep up with your portfolio*.
*If you’re worried by this, don’t be. This assumption is about as crazy as the assumption that one could earn a 12% return indefinitely. But Dave set the parameters.
So let me re-do the graph for you, with some extra columns:
Based on this, we’re saying that Ben saves the equivalent of about 40 meals worth at the age of 19. Arthur, on the other hand, is barely saving a single meal per year from the age of 48 onwards.
The point is: if you’re going to glibly assume that there’s a 12% return available out there, then you can’t just “fix a savings amount” at $2,000. You are no longer comparing the same things. And of course Ben is worth more at the end: in terms of real life sacrifice, he has forgone about 223 fun nights out, while Arthur has only missed out on 150 fine-dining experiences.
If you want to sort this out, you have to start by saying “both Ben and Arthur decide to pass on 40 restaurant dinners per year”. Then the graph looks like this:
Oh look! Arthur has saved more dinners-out. And he’s worth more. Well isn’t this less surprising.
So it looks like the real determinants of future wealth are:
- Knowing the difference between nominal and real returns (real returns are always “what can you buy with this?”, where nominal returns are “Oh look at these arbitrary money numbers”); and
- A solid saving habit.
So where is the compound interest?
Well, there isn’t too much compound interest up top – because I’ve made the real return equal to zero. That is: the investment return of 12% is matching the increase in the price of meals (also going up at 12%).
In real life, some of the return will come from improvements in productivity (like people being able to communicate faster with faster internet speeds, etc). And it won’t all come through as increased prices – because greater productivity, in general, means that people are getting wealthier (because they can do more).
So let’s say that the price of meals is only going up at 9% per year, while both Ben and Arthur are still able to get their 12% return.
Now we’re talking. Because even though it looks like Ben and Arthur have less in nominal terms (Arthur has saved $8,073,475, as opposed to $16,045,072); in real terms (ie. in terms of future dinners out), they’ve both saved more:
- Arthur has enough for 3,065 dinners, instead of 1,747; and
- Ben has enough for 1,139 dinners, instead of 358.
And that would be the power of compound interest: relative to his savings, Arthur has less than doubled his purchasing power capacity, where Ben’s purchasing power has almost tripled.
To Be Clear
That shift in purchasing power would be virtually the same if the inflation rate were 2% and the investment return 5%:
And I have to say that. Because this “12% return” business is madness.
The key take-home messages
- The earlier one starts saving, the better – agreed; but
- Saving more means saving more; and
- It’s not your bank balance that’s important, it’s what you can do with it.
Also – you haven’t missed out if you didn’t start early. The real benefit comes from the saving habit.
Rolling Alpha posts opinions on finance, economics, and the corporate life in general. Follow me on Twitter @RollingAlpha, and on Facebook at www.facebook.com/rollingalpha.
Siobhan July 31, 2015 at 09:29
“Knowing the difference between nominal and real returns (real returns are always “what can you buy with this?”, where nominal returns are “Oh look at these arbitrary money numbers”)”Reply
– Classic! Loved this!
Shayne January 5, 2016 at 22:36
Loved the article and the analysis on the value of money. We shared some similar thoughts on Dave’s teen millionaire: http://www.arkenstonefinancial.com/arkenstone-blog-posts/2015/6/19/the-problem-with-dave-ramseys-teen-millionaireReply
Anonymous February 26, 2018 at 20:16
Pretty sure you have missed the entire point of the original chart.Reply
RA February 26, 2018 at 20:17
And I am just as sure I haven’t.
But then, such is life, right? Not everyone will agree with you.Reply
Anonymous May 4, 2018 at 22:24
You HAVE missed the point – the numbers are frankly irrelevant, unless you are a picky geek. The point is that with 69% according to a CNBC study have less than $1000 in the bank and again according to CNBC “The median for all working-age families (in retirement savings) in the U.S. is just $5,000.” So The point of the chart is to get young people, in fact all people to start saving rather then spending every penny. Instead of criticizing come up with a constructive way yourself to get people out of poverty if you don’t like what “Dave is doing”Reply
RA May 4, 2018 at 23:15
Nope, I definitely haven’t missed the point. You have.
The post points out that Dave’s method actually underestimates the amount of saving that is required – and can result in situations such as “69% according to a CNBC study have less than $1000 in the bank”.
I’m saying that people have to save more, not less – and they should do so by adjusting their saving habit for inflation.
But perhaps that’s too constructive for you.
Maybe we should just save less, as you say.Reply
Anonymous May 20, 2018 at 00:20
You did miss the point. The point is early investment. Once you reach your mid 20’s the likely chance the average person will save money will drop astromically. Life gets busy for most people. And that is the point. Not all that bull crap statistical stuff you put together that’s just as wrong as Dave.Reply
RA May 20, 2018 at 09:17
Now you’re saying that Dave is wrong as well? No wonder you’re struggling with the maths.
Are you just here to confuse things? “THE POINT IS PEOPLE NEED TO SAVE MORE!” Yes, that’s what I’m saying. “NO, THE POINT IS PEOPLE NEED TO SAVE EARLY.” Saving early helps, but saving effectively over your lifetime is more important. “BUT PEOPLE CAN’T SAVE ANY MONEY AFTER THEIR MID-TWENTIES, BECAUSE LIFE GETS BUSY!” Okay, but then the problem here is life. “THE PROBLEM IS YOUR STATISTICAL MATH BLACK MAGIC VOODOO WITCHERY BULLCRAP.” So you agree that the problem is definitely life then.Reply
Anonymous August 5, 2019 at 20:47
This post is entirely inaccurate. It would have made more sense if you assumed 2% inflation per year at most, not 12%… Dave Ramsey’s chart is correct; money does hold value of it’s own.Reply
RA August 5, 2019 at 21:02
Lol! It also would have made more sense if Dave Ramsey had assumed a 2% return per year at most, not 12%… But, you know, thanks for playing 🙂Reply
Zoran Vidanovic October 19, 2019 at 21:44
You guys are great. Hahahaha
I love Dave. He’s doing a lot of good in the world even when you discount his preaching. On the other hand, dear Rolling Alpha, I love your mind. Keep up the good work. You’re the kind of person I would love to talk to, over coffee, of course; no pressure. I have a consideration I know you would like that I just proposed to my daughter. It takes care of the real issue of inflation by letting the floor rise with inflation AND it delivers on the promise of compounding by using money as means of production.
Son of God, adopted of course. 🙂