Albert Einstein was a smart guy.
…OK, OK, that’s an understatement. He was a genius. He is often credited with devising the “rule of 72″ – a formula that refers to dividing the rate of growth, for example 3%, into 72. The answer tells you how long it takes for money to double at a given rate of growth (i.e. 72 divided by 3 = 24. Meaning, it would take 24 years for money earning 3% to double. At 6% it takes 12 years to double). I have no idea if that’s actually true, but let’s run with it for a moment.
Often, this rule of 72 is invoked to charm the average investor into something of a hypnotic state while the adviser throws up wonderful looking charts and graphs to show that through the “magic” of compound interest, their client will double their money every 10 years.
However, there’s a deception hidden in there. First, you have to figure out whether your adviser is telling you average returns or real returns. By real returns I mean fixed rates – or guaranteed rates.
Also, keep in mind that the “rule of 72″ is not as much a rule as a guideline and it only works well with lower interest rate assumptions. For example if you are earning 7.2% on your money, then your money should double in 10 years…but the higher the interest rate assumption, the more distorted the calculation becomes. For example if you are earning 72% on your money, obviously it won’t double in a year (you’d need 100% rate of return to do that).
One other issue to discuss is the effect of negative returns and how they can affect the total amount of money you have earned. I know that may sound confusing, but allow me to explain:
If you start with $100,000 and you lose 10%, you are down to 90,000. If you gain 10% from there, you aren’t back to $100,000…you’re only at $99,000. Not a big deal? Well, think about this. Many people have lost 40% of their retirement savings during this turbulent market. So, if you had $100,000 and you lost 40%, that takes you down to $60,000. If your adviser is suggesting that you just “wait it out” hold onto your investments here is what will happen: even with a 40% gain, your investments only grew back to $84,000!
Most financial advisers believe that mutual funds are the greatest investment since sliced bread. They will tell you that you can average 8%-12% in a mutual fund…take that with a grain of salt and remember that this is an average. Averages don’t always translate into actual growth.
And, for mutual fund companies, they are usually telling you the simple average instead of the effective yield. If you were looking at a simple average, it means that you should expect some down years.
In the end, you may get about the same amount of money, but along the way, your balance may look very different depending on market conditions. This could be disastrous if a family emergency has you borrowing from your savings. For example, start with $100,000 and average 12% for 5 years:
Yr 1 = 20% = $120,000
Yr 2 = 4% = $124,800
Yr 3 = -10% = $112,320
yr 4 = 24% = $139,276
yr 5 = 22% = $169,916
Now, let’s repeat this example but use a straight 12% rate of return:
Yr 1 = 12% = $112,000
Yr 2 = 12% = $125,440
Yr 3 = 12% = $140,492
yr 4 = 12% = $157,351
yr 5 = 12% = $176,234
Now, let’s compare that with another scenario involving one down year in which you lost a catastrophic 40% (similar to what many people are going through right now):
Yr 1 = 25% = $125,000
Yr 2 = 30% = $162,500
Yr 3 = 20% = $195,000
yr 4 = 25% = $243,750
yr 5 = -40% = $146,250
As you can see, one catastrophic loss makes a dramatic difference in the results. Even so, the above scenario isn’t completely accurate. In my quest to show you average returns of 12%, you might have noticed that if I figured in a down year of 10% or 40%, that your other years had to be rather high. This is because we are measuring over a 5 year period, which is relatively short…which brings me to my next point.
Your financial adviser should be telling you returns over a specified period of time, not just rates of return. Is 20% over 4 years realistic? Probably not, unless you are investing in explosive sectors (which most people don’t invest in because they can’t stomach the down years). Are average returns of 8% over 20 years realistic? Maybe.
Just keep in mind that when you receive your investment return is far more important than your average return. Even if you do receive an average return of 8%, it tells you absolutely nothing about how much money you actually have in your savings.
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This entry was posted on January 5th, 2012 by David C Lewis, RFC. Edits may have been made to keep this entry current. · No Comments · Investing