So you read my post on How Compound Interest Works earlier, and started a little compounding project of your own, right?
So, you may have gone to one of those lovely compound interest calculators that festoon the internet, and plugged in some numbers. You may have gotten all excited about the results. Let’s take a look at what can happen when you calculate compound interest to the extreme!
First, we start with some assumptions:
Let’s say we start with no savings. Then, at the beginning of each month, we invest $500. We get a steady return of 6% per year. If we did this regular monthly investment and got a regular 6% per year return for 240 months (20 years), what would happen?
Wow, look at all that money! But doesn’t 6% seem a little low? Hasn’t the long-term return on the stock market been, like, 12%, or something?* What would happen if we had a 12% return?
Amazing! I’m almost halfway to being a millionaire! What if I double my savings? Will I make it to a million dollars?
If I put these numbers in the compounding calculator says I’ll practically be a millionaire! I wonder what happens if I start earlier and save over 30 years instead of 20?
Oh yeah, the stock market’s totally gonna make me rich! Richy, rich, rich. And if I save for 40 years? How would that compare to 30 and 20 years?
Just shy of $12 Million.
So, why aren’t there more twelve-millionaires? After all, all you have to do is invest $1000 per month for 40 years at 12% interest. That’s doable if you make a moderately above average income and live a noticeably below-average lifestyle. So why aren’t there more twelve-millionaires?
Because markets don’t really act like this. Since when has the stock market gently curved upward into a mountain of money? ProTip: Never. The stock market is known for up and down movement (among other things.) Notice anything suspicious? That’s right, kids. The compound interest curve never goes down. So, what’s going on here?
When you model returns into the future with stock market investments, you need to take possible volatility of returns into account. This is something I wish more people were aware of when they think about their retirement. Here’s a very, very rough savings outline courtesy of FIRECalc. It also starts with no savings, adds $12,000 per year to investments and is projected over 40 years. I just slapped this together and didn’t really do any due diligence on FIRECalc, so it’s not the worlds most valid model.
Looks a little different, doesn’t it. That’s because it’s calculating a variety of scenarios using past data to display a range of possible outcomes. Notice, it’s not a compound interest curve.
I’d also like to take a minute to point out the compound interest calculation assumes that the investment pays interest. Stocks can pay dividends, but these are usually** pretty insubstantial. Much of the gain people talk about coming from the stock market is from capital gains, which is the increase in price of the stock. That doesn’t really compound.
So, be careful when you play with the numbers of your compounding project. I wouldn’t want anyone to be disappointed.
* I’m not claiming it has. I just hear the old “12%” bandied about a lot, especially by a certain someone, so we’re going with it for the sake of the example.
** Keyword: Usually.