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Value of Investing

We have all heard that we can become millionaires if we put a few dollars a day towards savings.  The benefits of long-term compound growth are becoming well known.  If you invest $1,000 for 10, 20, or 30 years, you would earn the following depending on the rate of return:

 
3% return
5% return
8% return
10% return
Initial Investment
$1,000
$1,000
$1,000
$1,000
In 10 years
1,344
1,629
2,159
2,594
In 20 years
1,806
2,653
4,661
6,727
In 30 years
2,427
4,322
10,063
17,449

However, it is important to understand how inflation affects your return, that a dollar today will not have the same buying power in the future. Taking inflation into account (at 3%), the investments above will have the following buying power in today's dollars:

 
3% return
5% return
8% return
10% return
Initial Investment
$1,000
$1,000
$1,000
$1,000
In 10 years
1,000
1,212
1,606
1,930
In 20 years
1,000
1,469
2,580
3,725
In 30 years
1,000
1,780
4,146
7,188

There are two things to note. 

  • The power of compound interest:  The growth in return that is made in later years is significantly more than in initial years because the interest you earn each year is added to the initial investment (money makes money).  As shown above in the 10% scenario, in the first 10 years the $1,000 investment made $930 ($1,930 - $1,000) compared to $1,795 ($3,725 - $1,930) in the second 10 years and $3,463 ($7,188 - $3,725) in the third 10 years. 
  • Higher returns have a greater compounded effect: One would typically think that a 10% return would have twice the investment return of a 5% return.  However, it has almost a quadruple effect when factoring in inflation ($7,188 compared to $1,780 after 30 years).  This is because a 5% return adjusted for 3% inflation is approximately a 2% return while a 10% return adjusted for inflation is approximately 7% return, 3.5 times higher.

It is also important when trying to maximize the return on your investment, to watch out for investment management fees.  Some of these fees can be as high as 2% to 3% or can be as low as 0.25% in some indexed funds.  Some managers would argue that these higher fees are justified because they can offer a better return by selecting the hot sectors in the market.  Some studies have refuted these claims and have shown that most managers can not out-perform the market when their investment management fees are removed from their total return, in other words what is their return to the investor.  I will discuss this more in a later article.

A 2% fee may not sound that much.  However, over time it does add up.  After thirty years, avoiding a 2% management fee could increase a portfolio by over 70% :

 
10% vs. 8% return
Initial Investment
1.00
In 10 years
1.20
In 20 years
1.44
In 30 years
1.73

 

Investment management fees and inflation can kill your returns.  With a 2% investment management fee and 3% adjustment for inflation, your investment portfolio needs a 5% return to just treading water (keeping its value).  You can not control inflation but you can control investment management fees.
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