## Sunday, January 10, 2010

### Considering Inflation On "Equal" Investments

In response to my recent post entitled 5 Reasons Why Extra Cash Should Go To Retirement ASAP, one insightful commenter had this to say:
I think that to be fair, you need to take inflation into account when you assume rates of return and amounts of investment.  In terms of real dollars, saving \$2000 at age 25 is very different from saving \$2000 at age 50.

And 8% in real returns strikes me as pretty unrealistic.
These are certainly legitimate comments!  Let's take a look at the impact of inflation and what return we might expect.

First, I have to agree with the commenter that people should know and understand the impact of inflation on the value of money.  Let's take a look.  According to this site.  The average inflation from 2000-2010 was about 2.8%.

Assuming this average inflation rate stays the same, this means that \$2000 in today's dollars would be worth approximately \$4000 in 25 years.  Conversely, when you invest \$2000 in 25 years, it would be like only investing \$1000 right now.

That being said, we are really comparing the difference between investing \$2000 starting at 25 vs. 35.  That's only 10 years, so the difference is not as big - \$2636 as opposed to \$2000.  Conversely, when the person starting at age 35 invests \$2000, it has the same economic impact of the 25 year-old investing about \$1520.
That's still different, but not that significantly different.

So what would be the impact if the 35-year-old invests \$2636/year instead of \$200/year?  We know from the previous post, that (assuming a 10% rate of return) the person contributing \$2000/year from ages 25-35 ends up with about \$612K at age 65 and the person contributing \$2000/year from ages 35-65 ends up with about \$362K.  Using this calculator, we calculate what our return would be for 30 years (from ages 35-65) investing \$2636/year at 10% compounded daily - it comes out to about \$478K

The \$478K that we get from investing \$2636/year is better than the \$362K we got from investing \$2K/year from 35-65, but still far less than the \$612K that we got from investing \$2K from 25 to 35 and then stopping.

We see a similar result at an 8% projected rate of return, but the greater contribution from age 35-65 has more of an impact because the investment return is lesser. The person investing \$2000/year from 25-35 and then stopping ends up with \$324K while the person investing \$2000/year from 35-65 ends up with about \$241K and the person investing \$2636/year ends up with about \$317K

The main lesson to really take away is that the longer you give the investments to compound, the better - and that just a few years can have a big impact.  Inflation (and adjusting for it) always has an impact, but the power of compounding is just huge.

Next - As for the total return to project, I agree that it is difficult to project the return of the SP500 in the short term.  For example, the SP500's total return in 2009 was about +26.5%, while the total return in 2008 (one of the worst years in history) was -37%.  Of course, since 1976 the SP500 has averaged about 10.5%.  Wikipedia's page has some nice data.   Also, check out Vanguard's Statement here -they state that during the 20th century (1900-1999) stocks produced an annualized total return of 10.37%.

That being said, the last 10 years have been tough on the SP500 and it is essentially flat.  Conversely, my personal return on the SP500 portion of my investments over the last 10 years has been pretty good.  The volatility of the market has provided plenty of buying opportunities.

So what will the future hold?  My general belief is that we are going to see a regression to the mean - and the mean is 10-ish%/year.  Of course, running counter to that is the US's very poor financial position and potential for increasing taxes (which typically slows growth).  However, the last time I checked, the companies in the SP500 earned about 36% of their revenue outside the US, so they may not be as badly hurt by the US's lack of economic discipline.

Further, although I think that we will see a regression to the mean, the regression time could be decades.  However, for someone who is 25 today, they have 4 decades of investment ahead in their future.  I can't tell you what the return will be year-to-year, but I think that the total average return over those 4 decades will most likely be around 10%.

However, if you want to be a little more conservative over those 4 decades, say 8%.

In large part, I think that people's attitudes toward the SP500 are swayed based on the most recent performance and are not necessarily reflective of the SP500's long-term performance.  Contrast the attitude in 2000 that "anything less than 15%/year was inconceivable" with the attitude at the start of 2009 that "the SP500 was doomed - DOOMED!"  There have been periods of time when the SP500 underperformed for a long while - like during the great depression.  However, even considering the impact of the great depression, the average return for the 100 years of the 1900s was 10.37%.

The current economic crisis is bad, but it is not as bad as the great depression.  Let's take a look at the investment return that you got during the great depression.  The great depression is commonly considered to have started in 1929, but it really did not reach its bottom until about 1932.  Let's use this calculator to see what your annualized investment return would have been from January 1, 1929 to December 21, 1958 (30 years.)

We find that the annualized return even considering the great depression was 8.34%. Conversely, the current economic crisis is really not as bad as as the great depression and I would expect the annualized return for the next 30 years to be higher.  However, even if I am wrong, this seems to provide a reasonable basis for using 8% as a conservative figure for the SP500 average return over a 30-year period.

Further, I think that most people would agree that we are past the nadir of the current economic crisis.  Consequently, let's take a look at what your return would be like averaged over 30 years starting January 1, 1933 - after the worst point in the great depression.  That gives us an annualized return of 13.11% for those 30 years.

Consequently, I am going to submit that an 8% annualized rate of return for the SP500 over the next 30 years does not seem to be unreasonable.

1. "Also, check out Vanguard's Statement here -they state that during the 20th century (1900-1999) stocks produced an annualized total return of 10.37%."

Is that real returns or nominal returns? I am skeptical that it's real returns. In fact, the report you link to seems to give figures in the high 6 percent range for real returns in the 20th century. That sounds about right to me.

"So what would be the impact if the 35-year-old invests \$2636/year instead of \$200/year? "

It seems to me that you are still doing the calculation incorrectly since the impact of inflation over 30 years is a lot more signifcant than the impact over 10 years.

You should have the person saving \$2636 in year 1, \$2715 in year 2, and so on.

2. Another thing to consider is that your ability to put money aside tends to increase as time goes by. For one thing, if you have a 30 year fixed rate mortgage, the monthly payment is a bit lower (in real dollars) every year. For another, your earning power tends to go up as time goes by.

In terms of painfulness, it may very well be easier for most lawyers to put aside \$3000 per year from ages 35 to 65 than to put aside \$2000 per year from ages 25 to 35.

3. nycsolo - Ahh! I see what you were getting at. For those that don't know, in this context "Nominal" returns are the actual retuns provided by the index. However, you can then adjust the actual return of the index by the rate of inflation - which is what is being called "real" returns.

Calculating real returns can be useful. Consider a hypothetical where an index goes up 10%, but inflation is 10% that year. At the end of the year, you have more dollars, but the same spending power you started the year with. In this fashion, although the return produced by the index is typically growing about 10%/year, we have historically had inflation at about 3.08%/year (according to the Vanguard materials), so the real returns of the SP500 is more like 7%

However, in the origianl examples I was just using the actual index return. I am going to do a post in the future comparing the impact of inflation in investing, but it is a little complicated to get into here and using the inflation-adjusted return vs. the actual index return does not alter the main point of the post - save early and you won't have to save as much. how much less? It's going to vary, but often far, far less.

Finally, with regard to the proposed scenario where Associate B adjusts their investment for inflation each year during the 35, that's an interesting scenario and it would be informative to see how it turns out. (I can't seem to easily find a calculator that does it, though.)

However, for the purposes of our present example, recognize that Associate A contributed \$2000 each year for 10 years - that is, Associate A did not adjust his contributions yearly for inflation. If he had, his contribution in year 2 would have been more than \$2000. Thus, it would seem like the most direct comparison would be to have Associate B do the same thing - start with a set number and keep it up.

None of this disturbs the basic point - if you start saving earlier, you end up having to save less. How much less can vary with rate of return. To see this clearly, let's consider the following revised example. Associate A contributes for 10 years. In year 1 he contributes 2K, the next year he adjusts by inflation and contributes 2.8% more. He continues adjusting for inflation in each of the following 10 years.

Associate B also contributes for 10 years, but starting at age 35. Associate B's contribution is Associate A's original 2K contribution adjusted for inflation each year. That means that Associate B's first year contribution is \$2636. Consequently, when Associate B reaches 45 (10 years investing), Associate B has put away exactly as much as Associate A has in real dollar terms (adjusted for inflation terms.)

So now we have two associates who have made the exact same real, inflation-adjusted dollar contribution. However, Associate A's contribution has 30 years to grow until retirement, but Associate B's contribution only has 20 years to grow until retirement. Even applying an inflation-adjusted rate of return of 7% in this scenario, Associate A's total real investment value is going to be about double that of Associate B.

Maybe this is the clearest way to make this fundamental point - if you invest earlier, then you will have more in retirment. Perhaps the original example of having Associate B keep contributing detracts from the clarity of this point - if so, mea culpa.

In our example above, if Associate B invests for any more than 10 years, then Associat B is investing more than Associate A had to invest - and Associate B is going to have to invest more (about DOUBLE what Associate A had to) to end up with the same amount in retirement.

So, it seems like the bottom line is this - wait 10 years and you are going to have to pay double.

4. Hi nycsolo - In terms of "painfulness", of contributing a lesser amount for 10 years as opposed to contributing more for 30, I guess that it might be person and situation dependent. However, I have seen many people put it off and then just never get around to it - something always comes up - see #4 in my original post for a list. I know several lawyers who now have kids and pay tuition and really wish they had invested the money they had when they were 25 instead of taking a trip to Cancun or buying other toys. Their ability to put money away is much worse than at 25 because they have much higher fixed expenses. Maybe once the kids get out of college they will have more investable income, but by that time the lawyers will be about 50-55 years old. That doesn't leave them a lot of time to save up for retirement and leads to another phenomena that I often see - lawyers working when they are old (even 70+) and/or sick.

How about this for advice? If you want to lessen the odds that you are going to have to still be working in your 70s because you need the money, then find a way to start investing now.

I'll acknowledge and agree with your point that with a fixed mortgage, it gradually becomes less in real dollar terms. However, saving for college and having to pay for college seems to dwarf that.

5. You consistently write very insightful blog posts. How have you not been picked up by a finance magazine or newsletter? Have you considered a career in wealth management?

6. 10:27 - Thanks for the great compliment! As for being picked up by a magazine, I am really new to this whole blogging thing - I just started this blog in October 2009 - so I doubt I am on the radar screens of any publications yet. As for wealth management, the only wealth I manage right now is my own! Further, I'm a practicing lawyer and I make a pretty good buck right now, so I'm not in the market to make a career switch at this time. That being said, wealth management has always been interesting to me and I try to be continuously learning. If law was no longer an option, I think that I would try to aim for something in the wealth management area.