People tend to look at accumulating financial wealth as important but overlook the factors that make it work. There are several factors, and each is important in its own way. They are not of equal importance.
The money you will have in the future is a function of five factors:
Each of them matters, but net yield and time matter more than capital.
How they interact
You will understand it a little better if you can cope with the arithmetic.
The simplest case is a single sum invested for a time at some rate of return. If “P” is the deposit, “n” is the number of years and “i” is the yield, then Future Value (FV) = P*(1+i)^n.
(1+i)^n is the compounding factor. It is (1+i) times (1+i) times (1+i) repeated n times.
An example with i=8, n=30 and P= $10,000 made at the beginning of the first period.
In one year the future value would be $10,000 time 1.08 = $10,800. After 2 years it would be $11,664. Not $11,600 because the $800 you earned in year 1 earned 8% too.
You could use a spreadsheet or a calculator to convince yourself that after 30 years, you would have $100,626.57, of which $90,626.57 is new money.
How time affects it.
What if instead of 30 years, you had 35. Instead of $100,626.57, you would have $147,853.44 or $137,853.44 of new money. For 5 more years, you get $47,226.87 more money. That is more than 52% more money for 16.7% more time. To get the same in 30 years, you would need to begin with 52% more money. Time matters more than capital.
How costs affect it.
The common investment costs are taxes and fees. Suppose you pay fees at 1.5% of capital and pay taxes on investment income at 25% of net income. Your net income is 8% minus fees of 1.5% = 6.5%. Of that 6.5%, you pay taxes at 25% or 1.625% lost, to leave you with 4.875%.
After 30 years, you would have $41,702.22 for a net income of $31,702.22. Down from $90,626.57 you would have had with no costs. $58,924.35 less. 65% less even though yield dropped only 39%. To get the same $100,626.57, you must start with $24,129.78. That’s 141% more.
Costs matter much more than capital and more than time.
Think RRSP. The money you invest is before tax, so much larger than after tax. In a 35% tax bracket, $1,000 out of pocket becomes $1,538 invested. Increase capital (P) Taxes are payable only at the end of the investment time, so “i” is unaffected until you choose to pay the tax, usually after age 71. A dollar deferred is a dollar saved. Fees should be the same as for your usual investments. After all, an RRSP is just a container. What you put into it is the same as if it did not exist.
Example. $1,538 invested for 36 years at 6% net of fees becomes $12,530. In the worst case, and no one does it, say you paid all the taxes due at the end at 40%, leaving you with $7,518. To get the same answer with your after-tax $1,000, you need 5.76% net of fees and taxes. You need at least 8.75% to breakeven, and getting 8.75% for a long time is immensely harder than getting 6% net of fees alone. And all for no gain. You could work it out.
Start soon. Be fee and tax-sensitive. Invest well by learning more and having an external conscience to keep you on track.
The big first principle. You have to save some money.
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