Tuesday, July 17, 2012

The Magic of Compound Interest (2012 edition)

During a recent discussion with Stagflationary Mark about negative interest rates on short term government bonds, he referred me an article by Richard Russell on the magic of compound interest using 5 year US treasury notes or T-bills and the importance of starting early to save for retirement.

The article features a startling table of investment returns, showing that you really only have to save for seven years to secure your retirement if you can earn 10% on your savings. I have recreated the table below:

.

Richard Russell's DOW theory magic of compound interest (original)

.

.

Investor AInvestor B

.

AgeContribution Year End ValueContribution Year End Value

.

80000

.

90000

.

100000

.

110000

.

120000

.

130000

.

140000

.

150000

.

160000

.

170000

.

180000

.

190020002,200

.

200020004,620

.

210020007,282

.

2200200010,210

.

2300200013,431

.

2400200016,974

.

2500200020,872

.

2620002,200022,959

.

2720004,620025,255

.

2820007,282027,780

.

29200010,210030,558

.

30200013,431033,614

.

31200016,974036,976

.

32200020,872040,673

.

33200025,159044,741

.

34200029,875049,215

.

35200035,062054,136

.

36200040,769059,550

.

37200047,045065,505

.

38200053,950072,055

.

39200061,545079,261

.

40200069,899087,187

.

41200079,089095,905

.

42200089,1980105,496

.

432000100,3180116,045

.

442000112,5500127,650

.

452000126,0050140,415

.

462000140,8050154,456

.

472000157,0860169,902

.

482000174,9950186,892

.

492000194,6940205,581

.

502000216,3640226,140

.

512000240,2000248,754

.

522000266,4200273,629

.

532000295,2620300,992

.

542000326,9880331,091

.

552000361,8870364,200

.

562000400,2760400,620

.

572000442,5030440,682

.

582000488,9530484,750

.

592000540,0490533,225

.

602000596,2540586,548

.

612000658,0790645,203

.

622000726,0870709,723

.

632000800,8960780,695

.

642000883,1850858,765

.

652000973,7040944,641

.

.

Less Total Invested-80,000-14,000

.

.

Net Earnings893,704930,641


Awesome! Both investors retire with almost a million dollars. Investor B cruised after age 25, not having to invest a single dollar more.

But what happens if you can't earn 10% a year on your money? Instead of 5 year notes, let's go to the long end of the curve in 2012 and load up on 30 year treasury bonds at 2.6%. How do our investors fare now?

.

Richard Russell's DOW theory magic of compound interest (2012 edition)

.

Using 30 year US treasury rate of 2.6%

.

.

Investor AInvestor B

.

AgeContribution Year End ValueContribution Year End Value

.

80000

.

90000

.

100000

.

110000

.

120000

.

130000

.

140000

.

150000

.

160000

.

170000

.

180000

.

190020002,052

.

200020004,157

.

210020006,317

.

220020008,534

.

2300200010,808

.

2400200013,141

.

2500200015,534

.

2620002,052015,938

.

2720004,157016,353

.

2820006,317016,778

.

2920008,534017,214

.

30200010,808017,661

.

31200013,141018,121

.

32200015,534018,592

.

33200017,990019,075

.

34200020,510019,571

.

35200023,095020,080

.

36200025,748020,602

.

37200028,469021,138

.

38200031,261021,687

.

39200034,126022,251

.

40200037,065022,830

.

41200040,081023,423

.

42200043,175024,032

.

43200046,350024,657

.

44200049,607025,298

.

45200052,949025,956

.

46200056,377026,631

.

47200059,895027,323

.

48200063,504028,034

.

49200067,207028,762

.

50200071,007029,510

.

51200074,905030,278

.

52200078,904031,065

.

53200083,008031,872

.

54200087,218032,701

.

55200091,538033,551

.

56200095,970034,424

.

572000100,517035,319

.

582000105,182036,237

.

592000109,969037,179

.

602000114,880038,146

.

612000119,919039,138

.

622000125,089040,155

.

632000130,394041,199

.

642000135,836042,270

.

652000141,420043,369

.

.

Less Total Invested-80,000-14,000

.

.

Net Earnings61,42029,369

.

.


Ouch! This time investor A came out way ahead, but both are still in very big trouble. A lifetime of saving has left them without enough to retire comfortably. Maybe they would have done better speculating in stocks or betting on horses.

Just for fun, what happens if we stuck with safe 3 month T-bills, waiting for higher interest rates?

.

Richard Russell's DOW theory magic of compound interest (2012 edition)

.

Using 3 month T-bills at 0.1%

.

.

Investor AInvestor B

.

AgeContribution Year End ValueContribution Year End Value

.

80000

.

90000

.

100000

.

110000

.

120000

.

130000

.

140000

.

150000

.

160000

.

170000

.

180000

.

190020002,002

.

200020004,006

.

210020006,012

.

220020008,020

.

2300200010,030

.

2400200012,042

.

2500200014,056

.

2620002,002014,070

.

2720004,006014,084

.

2820006,012014,098

.

2920008,020014,112

.

30200010,030014,127

.

31200012,042014,141

.

32200014,056014,155

.

33200016,072014,169

.

34200018,090014,183

.

35200020,110014,197

.

36200022,132014,212

.

37200024,157014,226

.

38200026,183014,240

.

39200028,211014,254

.

40200030,241014,268

.

41200032,273014,283

.

42200034,308014,297

.

43200036,344014,311

.

44200038,382014,326

.

45200040,423014,340

.

46200042,465014,354

.

47200044,510014,369

.

48200046,556014,383

.

49200048,605014,397

.

50200050,655014,412

.

51200052,708014,426

.

52200054,763014,441

.

53200056,819014,455

.

54200058,878014,469

.

55200060,939014,484

.

56200063,002014,498

.

57200065,067014,513

.

58200067,134014,527

.

59200069,203014,542

.

60200071,274014,557

.

61200073,348014,571

.

62200075,423014,586

.

63200077,500014,600

.

64200079,580014,615

.

65200081,662014,629

.

.

Less Total Invested-80,000-14,000

.

.

Net Earnings1,662629

.

.


Oh my! The total of all interest earned from both investors combined over their entire working lives is less that $2,500. They both can now compete to be a Wal*Mart greeter, if they are better qualified than the other seniors. Surely they could have done better speculating in almost anything! (Caution: you are entering the sarcasm zone!)
Posted by tekewin at 18:57

2 comments:

  1. Stagflationary MarkJuly 17, 2012 at 11:29 PM

    In my opinion, the growth era is SO dead. It's just one exponential trend failure after another.

    Did you see Mish's article on CalPERS?

    July 17, 2012
    Calpers Pension Plan Reports 1% Return; Stunning "What If" Charts at Various Compound Annualized Rates-of-Return Going Forward

    I believe annualized returns for the next 10 years will be between 0% and 5% at most. I highly doubt they will be as good as 5%.

    For what it is worth, I think his estimate is spot on. You get 1.49% investing in the 10-year treasury. In theory, you can boost your return by a few percent by taking on more risk. In practice, that extra risk might end up contributing to a loss. That's why it is called risk! ;)

    As a side note, be sure to read the CalPERS link. They talk up how well their real estate holdings did. What a joke. The fund grew 1% overall. Genius it was not.

    ReplyDelete
  2. tekewinJuly 18, 2012 at 5:31 AM

    Stagflationary Mark,

    Yes, I read the Mish article and the official CalPERS release. I marked up some of my own charts and sent them to our finance director. No reply yet. It is a huge problem for pension funds, Social Security, and all retirees.

    ZIRP is a transfer of wealth from savers to debtors. That can only work for a while before the side effects have lasting unintended consequences. Just more bad mojo from not shutting down the banks in 2008.

    ReplyDelete

Subscribe to: Post Comments (Atom)