When it comes to slicing a pie, the idea of a half is pretty simple, and most of us would agree on whether the pie has been cut roughly in half. But with long-term investing, our sense of scale can fail us, and we can easily disagree on what it means to have half as big a return.
Suppose that a 25-year old receives a $10,000 gift from her grandparents and chooses to invest the money in a stock index and not touch it until she is 65. If the stock market returns 10% per year, she will end up with $452,600. Now what if she only got half of that return? What does “half” mean here?
One interpretation is that she gets only a 5% return each year. We might think that she will end up with about half as much money. The real answer: $70,400! What a difference. To end up with half as much money ($226,300), she would have to make 8.1% per year. A little 1.9% gap over 40 years cuts her final savings in half.
When it comes to making long-range investing plans, don’t place too much trust in your intuition. Small differences can matter, and “half” doesn’t always mean what we think.