We’re all in a race against the clock. How we handle the ups and downs sets us up for long-term success … or an ulcer.
Regardless of whether or not you work for someone else for your living, how we deploy our available resources over our lifetimes matters greatly. Most folks are familiar with the idea of compounding interest: where over enough time, your money makes a tremendous amount of money without you having to do much additional work. Once you have enough money to last your remaining lifetime, you’re financially free. So how do you get there? Making payday loans? Putting all your savings into a big pile of cold hard cash under your mattress or more comfortably into your closet?
Let’s explore the relationship between risk and reward.
Starting with the classic compounding interest chart from high school, we see a hypothetical pathway to awesomeness. 7% average returns from the time you start putting money into the Wall Street piggy bank. Put your hard earned cash into a bunch of 3-4 letter acronyms representing businesses. Add a bunch of time, and the road to Millionaire status couldn’t look simpler, right?
What this view fails to consider is volatility. Here’s what actual annual returns look like for the US market. Not such a smooth pathway is it?
OK, I admit that I played with the scales to make this look more equivalent. Here’s the first two plots overlaid on top of each other. Now you start to see why the stock market has been long-considered one of the best investment vehicles around. Cool, huh!? The point remains: you had to have some serious gumption to not sell as things were crashing in the late 90’s/early 00’s and 06-09.
Don’t feel like putting your investment dollars on a roller coaster? What if you want guaranteed returns? Just about the safest investment around is a CD. The FDIC guarantees all investments for up to $250k. In exchange for that nice safe blanket, you get low returns. Currently 0.5%-1.5% depending on the term. Long-term, CD rates look like this:
Where CDs may have once provided a decent return %, it’s now tough to lock up your funds for 12 months to 5 years in order to attain rates greater than an online savings account. Probably not the fastest way to financial freedom, right?
What if you are willing to take on a bit more risk than a CD? For example, it’s quite likely that the US will continue to meet it’s debt obligations. US Treasury bonds are historically one of the safest investments out there, especially relative to other countries with less stable economies or companies. Understanding how to assess bond risk and pick out what debt to invest in is beyond the scope of this post, so lets just stick with medium term US debt (10-year US Treasury Bonds). To simplify things, we’re also going to assume that we’re investing our $100 into a fund that costs nothing and lets us take advantage of annual rate changes while re-investing the interest.
Get to the point already, right!?
Let’s put it all together and see which investment strategy gets us closer in a hypothetical race. Let’s assume that most folks work about 40 years in their traditional 9 to 5’s. We’ll start with an initial investment of $1000. That’s right, $1000…and that’s it. If you invested $1000 at age 22, what is the theoretical balance for each when you’re 62? So, we’ll take the most recent couple of years for each of our asset classes (CDs, Bonds, and Stocks) and hold those interest rates constant for 40 years (I know, it’s a contrived example, but it’ll illustrate the point).
As expected, higher returns result in a higher ending balance at the end of one’s career. And, that’s the take-away: over a long enough time frame, maybe the short-term risk associated with asset volatility can be discounted. Maybe we spend too much time worrying about 0.25 point returns for a 60 month CD at one bank vs. a high-yield savings account. Instead, perhaps we should acknowledge that we are our own worst enemy. Our emotions when news headlines blare negative returns, tempt us into making bad decisions. We want to, “stop the bleeding.” We sell everything. In so doing, we typically take a big loss and miss out on the next market rebound. John Bogle might say just invest in the whole market regularly. Hold your investments for the long term. Keep your costs low.
I would distill that into an expression from Las Vegas and simply say, “let it ride!”