A while ago, I had some criticisms for a compound interest myth. Here’s the section (from Part 1) where I summarised said myth:
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.
And the summary of the criticism was:
- Sorry, but, a 12% return in the real world means lots of inflation. Borrowers don’t pay 12% returns unless they can generate returns in excess of 12%, which would mostly be from price inflation (and/or if they’re going into bankruptcy, which they won’t be doing for the 45 year time frame).
- So if there is lots of inflation, but old Arthur is insistent on only saving $2,000 per year, then Arthur isn’t actually saving very much. He’s making the mistake of thinking that ‘money’ is a fixed value item. It is not – especially over long periods of time.
- If you want an illustration, consider what would happen if we phrased this differently, and said that Ben and Arthur both agree that ‘saving’ means ‘saving what they would have spent on 40 meals out a year’. So if Ben starts saving when a meal out costs $50, and the price of a meal goes up by inflation of 12% every year, then you get this:
- Which should go to show you just how foolish it is to ‘fix’ saving amounts in nominal terms. Because the minute you throw inflation into the mix, then obviously, Arthur looks like an idiot.
- Which is exactly what he would be.
But then someone pointed out to me that I’d actually gone about this in a really complicated way – and that I really should just have focused on the 12% part. I mean, I mostly disagreed – because I think that people get far too hung up on this ‘the value of money should stay the same forever’ story. Money is a medium of exchange and a store of short term value – but money is not a store of long-term value. NOT. The Gold Standard days have come and gone, and they’ve been gone for almost half a century.
That said, I do think that I could have focused more on the 12% part.
Because let me replay the original scenario with some lower returns:
Which just goes to show that, given normal returns, it’s always better to be a consistent saver than it is to be an early saver who gets spendthrift after the age of 26. Of course, it’s probably best to be a consistent saver who starts early – even though this gets us on to existential questions about living your life and having fun while you’re young. But still. In normal terms, there is no doubt that doing it consistently is better than doing it early.
So fret not. You haven’t sacrificed your future wealth by having gone on the occasional holiday in your early twenties.
Rolling Alpha posts about finance, economics, and sometimes stuff that is only quite loosely related. Follow me on Twitter @RollingAlpha, or like my page on Facebook at www.facebook.com/rollingalpha. Or both.
Antonie Smith July 8, 2016 at 10:45
Thanks for this article, I enjoyed the 2nd last sentence most in today’s “saving” environment where the original article could very well deter people from saving whereas the reworked tables paints a great picture.Reply