Too good to be true, it can't be this simple can it?

[MrThatsDifferent]

Ok, so I was reading in one of the threads that if you invest your money and get around a 7% return, then you're money will generally double every 10 years. So if you have $100k invested in Vanguard in 2017 (and add nothing else), that will become $200k in 2027 and $400k in 2037.  Is that correct?

If so, then is this scenario possible: say I'm 40 and want to retire at 50 to slow travel the world for 10 years, then settle down and live comfortably somewhere. If I have $250k invested when I'm 40, that will become $500k at 50. I could pull out $250k, live off $25k a year for the rest of my life. The remaining $250k would double to $500k by 60, and I just repeat the process. Is this correct? I've oversimplified to understand the basic economics.

If so, then it seems you would need less than what people think, presuming it's invested and the returns are achieved. I'm not great with this stuff. It can't be this simple. Please help me understand what I'm missing or don't get.

Thanks and apologies in advance if I'm coming off like an idiot.

[StarBright]

You've got the gist of it.

It is one of the reasons experts recommend that young people invest as much as they can early on - the magic of compounding! But you wouldn't want to withdraw 250k at once. Just take the 25k you need and let the rest compound until you need the next year's money.

FWIW - obviously past returns do not guarantee future returns and all that. And there is a strong school of thought that thinks future markets will average less than 7% for the next decade or so (but they could also be wrong).

[sokoloff]

You have the basic idea, but the markets don't give you 7% every year like clockwork.

If you have $250K and get a -20% year followed by a -25% year, you have $150K left.

From a 30 year retirement angle, a 4% withdrawal rate is fairly safe, which for a $500K initial balance yields $20K in spending money per year. That's not that far from the $25K below, but you don't do it by pulling out $200K and spending it over 10 years. You need the $180K you aren't spending in year 1 growing in year 1.

[dandarc]

That is the basic idea of compounding.  Rule of 72 - divide 72 by your expected return, and that's about how long it takes to double your money.

But the proposed plan might fail spectacularly due to variation - investment returns do not work like clockwork.  As demonstrated in the chart here:


https://www.thebalance.com/rolling-index-returns-1973-mid-2009-4061795

The range of annualized returns varies a lot for various investments - if one of your decades happens to be one of low returns for your investments, you're going to regret having removed 50% at the beginning of the decade, because if you withdraw that next $250K, you might well wipe out the account entirely.

Even if you do manage to get your 7% steady returns, what about inflation?

Since you're generally holding whatever investments you hold because you expect them to perform well, a better plan is to simply leave the money invested and draw only what you need when you need it.  The account will usually go up by more than you withdraw (assuming you've chosen a reasonable withdrawal rate), and even if it has gone down, you're limiting the damage and leaving as much as possible invested to recover.

[Altons Bobs]

I was very confident that that was the case when I was in my 20's, dh could not convince me otherwise. Fast forward 20+ years later, I know for a fact that that wasn't the case at all, unless you've been very lucky. Don't expect to get 7% return on average unless you're super lucky.

[MrThatsDifferent]

Ok, thanks everyone. I didn't actually mean to pull all of the money out at once but I wanted to understand the concept. I think the not guaranteed 7% return is important to keep in mind. For some reason I find this to be even more comforting than the 4% withdrawal rule.

[frugledoc]

It is definitely not that simple.

7% per year compounded is not guaranteed, you could get far less or even lose money.  Obviously, I don't think that will be the case otherwise I wouldn't bother investing, but it could happen.

[sokoloff]

I find this to be even more comforting than the 4% withdrawal rule.

Rule of thumb, not rule.

[farfromfire]

You are also forgetting inflation.

Your $25K a year might be fine now.  20 years from now, it won't buy anything close to what it used to.

7% is typically cited after adjusting for inflation, and thus so are the rest of OP's numbers. In other words, s/he's good.

OP, sequence of returns risk can be mitigated by drawing 3.5-4% of your initial stash, so working until you have 625k-715k.

[JayKay]

I have a question about index fund investing and specifically compounding.

Generally, I think of compounding only happening if a reinvestment happens.  But, in the simple case of an index fund with little to no dividends, there's nothing that compounds it.  You have a certain number of shares, and those shares have simply gone up in value.  Unless you reinvest the (generally meager) dividends, you're not actually getting more of anything.

So, why do people use compounding interest math to model this type of investment?

[ixtap]

I have a question about index fund investing and specifically compounding.

Generally, I think of compounding only happening if a reinvestment happens.  But, in the simple case of an index fund with little to no dividends, there's nothing that compounds it.  You have a certain number of shares, and those shares have simply gone up in value.  Unless you reinvest the (generally meager) dividends, you're not actually getting more of anything.

So, why do people use compounding interest math to model this type of investment?

If a share price increases an average of 5% every year, that 5% is on top of last year's increased price. The math is exactly the same.

[JayKay]

If a share price increases an average of 5% every year, that 5% is on top of last year's increased price. The math is exactly the same.

Makes sense, thanks

[Interest Compound]

I was very confident that that was the case when I was in my 20's, dh could not convince me otherwise. Fast forward 20+ years later, I know for a fact that that wasn't the case at all, unless you've been very lucky. Don't expect to get 7% return on average unless you're super lucky.

If you started with $10,000 in 1987 (20 years ago), and added $1,000 a month, you'd have ended up with:





Those numbers look great to me! What am I missing?

[Gilly]

I was very confident that that was the case when I was in my 20's, dh could not convince me otherwise. Fast forward 20+ years later, I know for a fact that that wasn't the case at all, unless you've been very lucky. Don't expect to get 7% return on average unless you're super lucky.

If you started with $10,000 in 1987 (20 years ago), and added $1,000 a month, you'd have ended up with:





Those numbers look great to me! What am I missing?

That 1987 was 30 years ago?

[Interest Compound]

Hehe, thanks! But when I set the graph to 20 years, the CAGR is actually higher:


https://www.portfoliovisualizer.com/backtest-asset-class-allocation

So now what am I missing?

[Gilly]

I don't think you are missing anything in your analysis. However the best year vs worst year listed does a good job of emphasizing that 7% is not what can be consistently expected.
I'm puzzled why you were adding 1,000 per month, when a discussion on compounding is most easily conceptualized by an initial principal with only dividends being invested and the original post involved just an initial deposit. But, I can't fault the info you displayed.

[Interest Compound]

I don't think you are missing anything in your analysis. However the best year vs worst year listed does a good job of emphasizing that 7% is not what can be consistently expected.
I'm puzzled why you were adding 1,000 per month, when a discussion on compounding is most easily conceptualized by an initial principal with only dividends being invested and the original post involved just an initial deposit. But, I can't fault the info you displayed.

The IRR (Internal Rate of Return) value shows what the return would've been without contributions. My goal isn't to highlight compounding, but to show what returns would've actually looked like for an investor from 20 years ago. I presume most people here would be making regular contributions, so I think a graph like this is a better fit to answer "Too good to be true, it can't be this simple can it?"

Either way, despite having two market crashes in this timeline, both the CAGR and IRR figures look great to me.