Your future financial wealth depends on three things. Only two of them matter.
The three things are:
- Money Invested (Capital)
- Duration of Investment
- Net Yield
Capital matters least and that is a good thing because many have little of it. They can get it by saving and that is controllable. People can influence but not control the other two.
They are processes.
Start earlier. Know how long it takes to double your money. No matter what the net rate of return may be, the last double accounts for half the money you earn. Having a little longer makes an enormous difference. For example, at 8% money doubles about every nine years. In 45 years you get five doubles or 32 times your money. In 36 years you get roughly 4 doubles or 16 times your money. $1,000 is worth either $32,000 or $16,000
If you want to get $32,000 and also want to wait to start, you can do it. Start with $2,000. (Buy the first double) or invest at 10%. It easier to get 8% than 10%, although both are difficult. You must also answer the question, “Why will you have $2,000 later, but not $1,000 now”
The moral: Start sooner even if it is with just a little money.
It does not matter how much you make, it matters how much you keep. Like playing pool, what is left is what matters. There are material reductions in yield that you cannot ignore. Investment fees matter, but so would the cost to do it yourself. Unnecessary losses, time, expenses and so on. The big negative is income taxes.
Income taxes compound. The long term rate is immensely higher than the annual rate that you know about. If you earn 8% and pay 40% to income taxes, by the time 45 years pass your effective tax rate is 76.6%. Instead of $32,000 you have $7,246. You will need nearly five times the capital to reach your goal.
The moral: Learn to manage taxes and other yield reducing factors.
In late 2012, someone estimated that Alaska was worth $5 trillion and maybe the US should sell it. They paid $7.2 million, so a fine investment. But they have had it for 147 years.
What is the rate of return?
There is a simple method to guess. The rule of 72 says that the time to double is about 72 divided by the interest rate. We know that Alaska is worth roughly 695,000 times as much as it cost. We know also that 2 to the power 19 is about 525,000 and 2 to the twentieth is more than 1,000,000 so about 19.4 doubles. 147 divided by 19.4 is 7.577 years for each double and 72 divided by that is around 9.5%.
The real answer is 9.58%.
That rate of return should trouble you if you are expecting to make anything over 7% pretax. There are not so many high yielding investments around that last a long time.
Be cautious when making your retirement plan. You will find it is easier to explain why you have too much money, than it is to explain why you have too little. Or maybe you could retire a little earlier if everything breaks for you.
The moral: Be cautious with high yield estimates.
Start early, be cautious with yield estimates so your expectations are reasonable, invest wisely and manage taxes. Just process.
Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.