The "Turtle" and the Hare!
Saw this little guy on my driveway.
Besides an unfortunate reminder of how fast I'm running these days, this turtle should be a constant reminder of how money grows most efficiently.
Most retirement calculators like the ones you might find on the Internet assume a linear rate of return. That is - if you enter 5% growth, the analysis will factor in a linear 5% return.
How can I say this diplomatically. That's sort of a scam.
Money DOES NOT grow that way. Assuming linear growth might make the results look good, but if you rely on this level of investment growth to determine your spending in retirement, it may come back to bite you.
Scenario one: we are assuming a constant 5% rate of return and a nice bit of compounding. (NOTE: This only works if you are getting the same return year after year!)
In the end we have 28% growth. The average annual rate of return is 5%, but because of compounding, we got that extra bump. This is like the turtle. Slow and steady.
What if the returns are more volatile?
In Scenario 2 - we lose almost 5% in the first year, as compared to scenario 1 - a 5% increase. This would leave you with nearly 100K less after one year and, unfortunately, you would be one year closer to retirement. Not good!
In Scenario 3, there is one bad year followed by a few muddling years - then a good one! (20%). Because of the big loss in year one - after 5 years your retirement funds have only increased by 9% overall. You had some compound returns, but you started at a lower base because the first year returns were so bad.
Here's the point:
Do not assume a linear rate of return like most retirement calculators use. Lower yearly returns (with a chance at COMPOUNDING) is a more favorable scenario. Certainly, when compared to years of up and down (volatile) returns. As you get closer to retirement, this concept is even more magnified.
Compounding is a well mis-understood topic. It only works when you avoid large losses. This is why when choosing between the tortoise (in this case the turtle) and the hare, always choose the turtle.