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The Hidden Realities of Compound Interest & Saving!

The sad reality is that most of what we are taught about savings and how compound interest works is completely wrong, now I am all for saving money and having it work for you so lets break some of this down.

There are a few popular savings models lets call them out there, I even broke one down in a video I shot where I cover how quick saving $10 per day starting at age 25, with a 7% ROI adds up to $1M by age 69, but what nobody talks about is the fact they are deeply flawed and not complete. I say this because these “feel good” savings models usually don’t take into consideration time lost for losses (typical market cycles over that many years will see at least one correction), they don’t adjust for inflation and usually they don’t actually take into consideration quality of life at time of retirement.

Lets start off setting some context here, first off the average American has $6,506 in credit card debt according to May 2019 Experian data, and the median income in 2019 is $63, 688. Furthermore 63% of Americans do NOT set annual savings goals and 23% report they put 0% of their monthly paycheck into savings. So that is one quarter that doesn’t even put money into savings.

The realities of taking a loss…

For sake of example lets say you were going after the above used number of 7% per year APR, do you know that if you take loss for just one year, you loose the compound interest effect. It will then take you 28% to catch up that original 7% loss, skewing the results to that nice and clean 7% APR for 40+ years. In every market it follows a market cycle, and that cycle includes a mark down period or draw down period, its just how markets work- they can’t go up forever. These draw down periods can last 10-20 years where you would actually report losses on your investment.

the red is the negative returns areas, click image for full size

How much should I have in savings?

You see a lot of misinformation here as well, a common talking point you hear is that you should have 2.5x your current income at age 40 in savings, this too is wrong because its not adjusted for inflation and quality of life at time of retirement.

Most people will want to at least live the same quality of life then what they have before retirement but some will require even more, which requires more money.

Here is an illustration of the savings gap.

click for full size

Finally Inflation rate

Based on the last two decades we can base and adjust inflation to 2.1%, which will give you something like this….

Left is what you make now, right is income required in 30 years

Keep in mind that if the inflation rate runs up at any point the above numbers are no longer accurate. Looking at the above you can see that things aren’t as black and white as many think, there are other factors that most people don’t think about, inflation will always affect the bottom line numbers.

Here is the same data adjusted for inflation with a few additions, the red number is the amount of asset required to pull out 4% and assuming 2.5x current income. So if you want to live on $100k you will need almost $5M in assets.

Its becoming really really obvious that firstly you need at least one side hustle, average person brings in an extra $1,122 per month but unfortunately roughly 1/3 of those people need that money for bills and to stay afloat. Investing in yourself is now more important than ever, pay yourself in education and by saving. Next its not enough to have just savings in your portfolio, you need cash flow and active investment ROI coming in, beyond just dividend payouts.

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