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Long-Term Investing Confuses Our Sense of Scale

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.

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Comments

  1. geneMay 10, 2012 at 9:09 AM

    That 1.9% certainly does make a big difference. A big incentive to take up passive low-cost index investing. Little things like decreasing activity and the accompanying taxes, spreads, and commissions can be significant over an investing career.

    I have been buying some small-cap US stocks over the last couple years, but I'm starting to move to $1B+ stocks just to get the spreads down to a couple of cents, versus the 1% or more in some smaller issues.

    ReplyDelete
  2. Michael JamesMay 10, 2012 at 10:45 AM

    @Gene: I've known a few people over the years who have tried to make money with high-risk option strategies. They got hammered by both the volatility and by the big spreads on option prices.

    ReplyDelete
  3. WaltMay 18, 2012 at 12:46 PM

    Wow - thanks for highlighting this. I've never put faith in the calcs institutions make (i.e. 8%/10%) because they're aren't realistic in my mind. Seeing your little analysis makes me feel a little more confident about the investing decisions made and the returns I'll likely get.

    Thanks

    ReplyDelete

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