Author Topic: When Compounding Returns Isnít That Important  (Read 5973 times)

arebelspy

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When Compounding Returns Isnít That Important
« on: July 18, 2012, 10:55:23 AM »
So we've discussed before why the interest rate you get isn't nearly as important as your savings rate.

http://www.mrmoneymustache.com/forum/investor-alley/savings-rate/

This is especially so for early retirees, who have less time for compounding to take effect in their accumulation years, so the amount they are saving vastly outweighs the amount their portfolio is earning at that time.

I just ran across this article, which argues why compounding returns aren't worth chasing - even over a long period of time.

http://www.whatithinkabout.com/why-compounding-returns-isnt-that-important/

From the article:
Quote
[This example assumes you can earn, though your hard work, 4% more than the market.] Say you are holding a pretty decent job at $50/hour, and you spend 15 hours/week studying companies and analyzing stocks. That is a total of 780 hours per year, valued at $39,000! [Based on your hourly wage.] So in order to justify spending that time this year, youíll need to have invested $975,000! You need almost a million dollars and a sure 4% increase [over the market] to breakeven on the amount of time you spent on it!

Now it has some flaws and oversimplifies things, but the general premise is correct, IMO.  If you're spending a lot of time trying to increase the yield on your portfolio, your hourly rate is terrible. It's just not worth it.

In addition, there will be years where you underperform the market.  Experts can't beat the market after fees, but even if you can by a few percent - every single year - you're very likely earning less per hour than you are at your job.

Low cost index funds are the way to go, and then spend your time earning more or finding ways to spend less - or just go do something you enjoy.

Unless investing is something you love and would be doing for free for fun anyways, there's much better ways to spend your time.
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igthebold

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Re: When Compounding Returns Isnít That Important
« Reply #1 on: July 18, 2012, 11:26:53 AM »
In addition, there will be years where you underperform the market.  Experts can't beat the market after fees, but even if you can by a few percent - every single year - you're very likely earning less per hour than you are at your job.

Very interesting. For some reason I'd never thought of it that way.. I always assumed getting a higher rate of return sooner would compound over the years to an amazing difference. This makes me even more comfortable with a "just do index funds" approach, focusing on increasing my savings rate.

arebelspy

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Re: When Compounding Returns Isnít That Important
« Reply #2 on: July 18, 2012, 11:32:10 AM »
Very interesting. For some reason I'd never thought of it that way.. I always assumed getting a higher rate of return sooner would compound over the years to an amazing difference. This makes me even more comfortable with a "just do index funds" approach, focusing on increasing my savings rate.

Oh, it certainly will.  But it'll underperform compared to if you spent those early years earning and saving more, and earning a few percent less return and being happy with index funds.  The larger amount of money saved early on will make much more of a difference than the little extra percent earned early on, and that's the amount that will be compounding.

I agree, when hearing about compound interest rates, it's easy to get caught up in what a few percent can do.  The example he opens up with shows an astonishing difference due to interest rates.

But focusing on that when you could just earn more money will actually cost you money in the long run, since you'll be working for (very likely) less than your hourly wage, even if you can beat the market year after year.
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gecko10x

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Re: When Compounding Returns Isnít That Important
« Reply #3 on: July 18, 2012, 12:11:34 PM »
Disclaimer: Have not read the article.

It seems unrealistic to me to compare everything to an hourly rate, unless you could actually bill someone for your time spent investing. Maybe that sounds like a silly statement, so let me elaborate: If I have a salaried job, it makes no difference what hourly wage I earn, as I cannot bill my employer for additional hours worked. Similarly, if I DO charge an hourly rate for my time, but could not find or manage additional clients, it also makes no difference what my rate is for comparison purposes.

It only seems to be a relevant comparison if the time spent investing could realistically be spent on billable work.

grantmeaname

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Re: When Compounding Returns Isnít That Important
« Reply #4 on: July 18, 2012, 12:20:04 PM »
Even without the hourly rate comparison, the point remains that it's relatively insignificant compared to cutting expenditures or finding a way to increase your income.

darkelenchus

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Re: When Compounding Returns Isnít That Important
« Reply #5 on: July 18, 2012, 12:22:51 PM »
Even without the hourly rate comparison, the point remains that it's relatively insignificant compared to cutting expenditures or finding a way to increase your income.

Seconded. The point is that it'll lead to diminishing returns on your time.

arebelspy

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Re: When Compounding Returns Isnít That Important
« Reply #6 on: July 18, 2012, 12:37:28 PM »
Gecko: That's true.  And Grant makes a good point.  To add to that, the article concludes with the idea that it is likely your free time is better spent growing your business or improving your career, rather than spending time on investments.  So you could compare that hourly (as you could be growing a side business, gaining more qualifications to earn you more in your current field, etc.)

And that aside, I think the alternate perspective may help one realize they don't have to spend all of their time chasing yield for diminishing returns, but it's okay to relax and enjoy your time.

That is, if one realizes the time they're spending on investing is $3/hour... would they still be doing it?  Maybe for some it's enjoyable enough that they would.  But I'd bet many, by breaking it down hourly, would realize they wouldn't want to work for those wages. 

It's a YMOYL type perspective.
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velocistar237

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Re: When Compounding Returns Isnít That Important
« Reply #7 on: July 18, 2012, 12:46:14 PM »
Jacob (ERE) has pointed out that investment return isn't that important while you're working, because you haven't accumulated enough for it to be worth your time. (Sorry, I couldn't find the post.) On the flip side, though, he advocated learning how to invest by the time your portfolio reaches a certain point. For one, you can reduce your fund expenses if you roll your own index fund, but he also firmly believes that an investor can beat the market, base on his experience. I'm not sure what to think of that.

arebelspy

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Re: When Compounding Returns Isnít That Important
« Reply #8 on: July 18, 2012, 01:03:49 PM »
Jacob (ERE) has pointed out that investment return isn't that important while you're working, because you haven't accumulated enough for it to be worth your time. (Sorry, I couldn't find the post.) On the flip side, though, he advocated learning how to invest by the time your portfolio reaches a certain point. For one, you can reduce your fund expenses if you roll your own index fund, but he also firmly believes that an investor can beat the market, base on his experience. I'm not sure what to think of that.

Will most Mustachians ever hit that point?  I just don't think it's worth it, running the numbers, unless your portfolio is huge. And most Mustachians, living on relatively little, won't accumulate a giant portfolio.

For Jacob, it definitely wouldn't be worth it (based on his portfolio size). 

I'd rather be completely FI and not have to worry about the "work" of trying to beat the market than have to stay on top of investments daily for the next 50 years. And since you get such a better hourly wage now working, it's much easier to accumulate that excess to where a 6% return is enough (instead of the 7 or 8% you might eek out).
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James

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Re: When Compounding Returns Isnít That Important
« Reply #9 on: July 18, 2012, 02:59:10 PM »
Jacob (ERE) has pointed out that investment return isn't that important while you're working, because you haven't accumulated enough for it to be worth your time. (Sorry, I couldn't find the post.) On the flip side, though, he advocated learning how to invest by the time your portfolio reaches a certain point. For one, you can reduce your fund expenses if you roll your own index fund, but he also firmly believes that an investor can beat the market, base on his experience. I'm not sure what to think of that.


Rolling your own index doesn't save much, I'd rather work an extra couple months which would cover any extra needed to cover index fund fees.  For others that number might be different and more worthwhile.


Managing investments is something I would definitely work at my job longer to avoid.  I have absolutely no desire to manage money, while I enjoy my day job.  Thankfully what I believe about my ability (and most other's ability) to beat the market meshes with this plan.


Having said that I would also work a while longer at my day job to have a small pot of money to play with in various markets.  I could throw that into a company that I believe might be the next Apple, or take a calculated gamble at winning big with some investment, or buy real estate, etc.

arebelspy

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Re: When Compounding Returns Isnít That Important
« Reply #10 on: July 18, 2012, 03:35:57 PM »
Having said that I would also work a while longer at my day job to have a small pot of money to play with in various markets.  I could throw that into a company that I believe might be the next Apple, or take a calculated gamble at winning big with some investment, or buy real estate, etc.

Sure, absolutely.  Play money, for a hobby.

Above, beyond, and separate from FI money, and akin to what one might spend on another expensive hobby.  That seems perfectly reasonable.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with two kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
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JohnGalt

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Re: When Compounding Returns Isnít That Important
« Reply #11 on: July 18, 2012, 03:57:44 PM »
Jacob (ERE) has pointed out that investment return isn't that important while you're working, because you haven't accumulated enough for it to be worth your time. (Sorry, I couldn't find the post.) On the flip side, though, he advocated learning how to invest by the time your portfolio reaches a certain point. For one, you can reduce your fund expenses if you roll your own index fund, but he also firmly believes that an investor can beat the market, base on his experience. I'm not sure what to think of that.


Rolling your own index doesn't save much, I'd rather work an extra couple months which would cover any extra needed to cover index fund fees.  For others that number might be different and more worthwhile.


Managing investments is something I would definitely work at my job longer to avoid.  I have absolutely no desire to manage money, while I enjoy my day job.  Thankfully what I believe about my ability (and most other's ability) to beat the market meshes with this plan.


Having said that I would also work a while longer at my day job to have a small pot of money to play with in various markets.  I could throw that into a company that I believe might be the next Apple, or take a calculated gamble at winning big with some investment, or buy real estate, etc.

I'm 100% in agreement with James on this.  I have such little confidence in my ability (and almost as little interest in learning) to do well being an active trader that I would rather work longer and not have to worry about it instead of spending the rest of my life worrying about beating the market. 

If I want higher returns - I'd rather invest a portion of my portfolio in a something I could be directly involved with helping grow.  But then... that's really my goal for getting FI money.  I don't want to retire, I want the freedom to take chances on my own interests/ventures.  If I was interested in trading stock - that could be one such venture, but I'd rather eek out a crappy hourly return at the poker table (which is very similar to day trading), owning rental property, or starting/investing in some small business. 

So... I say if you enjoy trading stocks and are good at it, go for it.  But, if you're just looking to increase your returns, your time would probably be better spent (and valued) elsewhere.

smedleyb

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Re: When Compounding Returns Isnít That Important
« Reply #12 on: July 18, 2012, 05:02:53 PM »
Jacob (ERE) has pointed out that investment return isn't that important while you're working, because you haven't accumulated enough for it to be worth your time. (Sorry, I couldn't find the post.) On the flip side, though, he advocated learning how to invest by the time your portfolio reaches a certain point. For one, you can reduce your fund expenses if you roll your own index fund, but he also firmly believes that an investor can beat the market, base on his experience. I'm not sure what to think of that.

Scandalous!

James, attempting to find the next Apple is a fools errand. 

Studying up on global economic trends to locate the areas/sectors that will drive the world's economies in and into the future -- commodity scarcity, alternative energy, emerging markets -- that is a different animal altogether, and something any well-read and critically minded mustachian can and should get behind in order to expedite the move to FI. 

How this endeavor is synonymous with "gambling" in some people's vocabulary is beyond me.

grantmeaname

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Re: When Compounding Returns Isnít That Important
« Reply #13 on: July 18, 2012, 07:37:40 PM »
Scandalous!
Yet nobody here but you is scandalized.
Quote
Studying up on global economic trends to locate the areas/sectors that will drive the world's economies in and into the future -- commodity scarcity, alternative energy, emerging markets -- that is a different animal altogether, and something any well-read and critically minded mustachian can and should get behind in order to expedite the move to FI.
By your own admission, better-than-market performance is not repeatable.

smedleyb

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Re: When Compounding Returns Isnít That Important
« Reply #14 on: July 18, 2012, 09:11:19 PM »
Scandalous!
Yet nobody here but you is scandalized.

If only "here" represented something more than us five or six anonymous dudes debating stocks on the internets.

Jamesqf

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Re: When Compounding Returns Isn’t That Important
« Reply #15 on: July 19, 2012, 01:46:43 PM »
Low cost index funds are the way to go, and then spend your time earning more or finding ways to spend less - or just go do something you enjoy.

I would question this.  Funds, yes.  Low cost, yes.  But from my own (admittedly limited) experience, I'd rather go with a "value" fund.  The index fund I have has, over the last 10 years, returned 5.08% with a 0.3% expense ratio.  The couple of value funds returned around 8.5%, with about 0.8% expense. 

And for comparison, the fairly conservative stock & bond fund where I park my emergency reserve has returned 7.05% with 0.69% ER over the same 10 years, and didn't fall off a cliff in the fall of '08, either :-)