If there’s anything about investing and saving that’s easy to understand, it’s that more is more. If you save more, you invest more. If you save less, you invest less.
But what really drives our retirement savings plan to a higher balance over time? Is it market gains that do the work, or just putting in more money?
It’s the compounding, really. To understand why, you have to understand first why you invest all.
Putting money into stocks and bonds is an act of faith, somewhat supported by long experience and data. It’s faith that investments will continue to outpace inflation.
That’s important because inflation never stops. Markets go up and down, sometimes dramatically. Yet inflation virtually never goes in any direction but up.
To find deflation in the U.S. economy you have to go back to the 1930s and the Great Depression. Before that, deflation was a fairly common event, happening every 30 or 40 years.
For a lot of historical reasons, deflation is much less of a risk than in years past, but the flip side of that coin is inflation. Rapid rises in prices have happened in recent memory. Ask anyone who lived through the 1970s.
Of course, over the past decade we’ve seen extremely low inflation, again the result of many factors. You can think of inflation as the economy’s pulse. We have one, but it has been fairly weak.
You could bet that inflation will remain low and keep your savings in cash. Yet the more likely outcome, based on past experience, is that inflation will return.
Owning investments is taking the position that beating inflation matters. Having more dollars that buy less goods in the coming years will be cold comfort.
So why is compounding so important? Because investors need their cash to beat not just inflation but to grow substantially.
Consider what happens in an investment environment of, say, a 7.2% return. We select that figure because it’s not too far off the recent historical reality of portfolio investing and because that return means your cash doubles in value in 10 years.
Historical inflation of about 3 percent, meanwhile, means losing purchasing power as time passes.
In dollar terms, $100 invested in the market should become $200 in 10 years while the thing you want to buy for $100 will cost you about $134 in the same time period of a decade. Not a bad outcome.
Let’s say you have 30 years to retirement. Your $100 compounds, which means it doubles to $200 in about 10 years. Then it doubles again to $400 one decade later.
After the third decade, your initial investment should become $800. Inflation, meanwhile, means your $100 purchase will cost $243. But that’s okay if you have $800 to spend.
Here’s the bottom line. If you don’t set aside that $100, it doesn’t matter how many years it’s invested or what rate of return you earn. Nothing compounds into nothing. Very little compounds into not much.
Worry less about your rate of return. Worry more about saving steadily and being invested, and let the magic of compounding take care of the rest.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.