Tag Archives: Compounding

The Miracle of Compounding Illustrated: How Much Easier Is It to Save $1 Million If You Start In Your 20’s?

27 Wednesday Apr 2016

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MO Savs For $1 Million

So you are in your 20’s or 30’s and retirement seems so far away. Why bother saving for the future when there are so many things vying for priority in your budget today? This chart is a great illustration of why. To reach $1 million before tax at a 6.5% annual return by your 65th birthday requires saving $438 a month starting at age 25, $904 a month starting at age 35, or $5,938 a month starting at age 55.

These are just illustrations, and they make no heroic assumptions about sky-high returns. You could do a lot worse than an index fund or target retirement fund from Vanguard. Just don’t invest money earmarked for a short-term need like living expenses or a downpayment on a house in the stock market. Put an amount in month after month, in up markets and down, and raise it if your income allows. Start your snowball young and give it a long time to build. Decades from now you will be happy you did.

Beyond putting the money aside, your biggest temptation may be to sell or at least stop buying when the stock market has one of its occasional meltdowns. As long as you are broadly diversified and won’t need to touch the money for 5 to 10 years or more, you should ignore the market’s gyrations. The real risk in investing is the loss of purchasing power from inflation. Don Yacktman really seared this into my brain in this video when he made this point: 3% inflation for 100 years turns a dollar into a nickel. This is why your long-term money should be stock heavy.

Life is all about choices and tradeoffs, and it can be hard to choose between spending now or investing for far away in the future. First of all, stay out of debt beyond a home mortgage, a car payment, or student loans. Paying debt down first makes a lot of sense. Beyond that, anything you put away today will make it much easier to reach your goals later. Your future self will thank you.

See also:

How Have Stocks Fared the Past 50 Years? You’ll Be Surprised

Beware of These Cognitive Biases

Charlie Munger’s Investment Principles And Checklists [IN-DEPTH]

S&P 500 Trailing 12-Month P/E Ratio Hits Six-Year High

Stocks That Triple In One Year

Karl Popper on The Line Between Science and Pseudoscience

“The future should be viewed not as a fixed outcome that’s destined to happen and capable of being predicted, but as a range of possibilities and, hopefully on the basis of insight into their respective likelihoods, as a probability distribution.”
— Howard Marks

Charlie Munger and The Miracle of Tax-Efficient Compounding

28 Thursday Nov 2013

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On this Thanksgiving, I’m thankful for the wisdom of Charlie Munger and the miracle of tax-efficient compounding. Charlie is Warren Buffett’s plainspoken and less-famous partner. This is his quote on the simple but stunning power of tax-efficient compounding:

Another very simple effect I very seldom see discussed either by investment managers or anybody else is the effect of taxes. If you’re going to buy something which compounds for 30 years at 15% per annum and you pay one 35% tax at the very end, the way that works out is that after taxes, you keep 13.3% per annum. In contrast, if you bought the same investment, but had to pay taxes every year of 35% out of the 15% that you earned, then your return would be 15% minus 35% of 15% or only 9.75% per year compounded. So the difference there is over 3.5%. And what 3.5% does to the numbers over long holding periods like 30 years is truly eye-opening. If you sit back for long, long stretches in great companies, you can get a huge edge from nothing but the way that income taxes work.

This isn’t exciting to talk about, but it is where the rubber really meets the road in terms of investment success. 3.55% per year outperformance after taxes is incredible, and you don’t have to pay a hedge fund “2 and 20” to get it.

Wes Gray at the Turnkey Analyst does the math on how much difference this can make on an initial investment of $100 over 30 years:

Microsoft-Excel-mungertax11

Alpha is interesting; taxes are AMAZING.

You end up with $4,235.43 for the 13.3% strategy and $1629.81 for the 9.75% strategy.

Charlie Munger Translation: Taxes and Alpha Are the Shiznit!

This should be in neon lights. The tax-efficient strategy gives you a 4,235.43% return over 30 years, while the tax-inefficient strategy gives you a 1,629.81% return over 30 years. That’s up more than 42 times versus up more than 16 times. On a $10,000 initial investment, that’s a 30 year total of $423,543 versus $162,981. Stunning results.

Alpha is investment-speak for risk-adjusted outperformance of a benchmark. It is the Holy Grail for which all investment managers aim. But the impact of taxes is more important and less talked about. Turn off the noise on CNBC and focus on maximizing your after-tax return. It may not make for exciting dinner-party conversation, but what matters is not what you earn, it’s what you keep.