The Fallacy of Compounding Returns |
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I often find myself discussing economic issues with my friends. Some discussions can get very technical especially with some highly technical, highly skilled friends. What I've posted below is a direct transcript of what Larry sent me regarding private pensions and compounding returns.
The case described has probably happened to millions of accounts in the US.
Mathematically, compounding returns generate huge returns over time. If an investment grows on average 10% annually for 30 years, you get a 1700% return over that time. This is the rationale behind private pensions. However, two facts make this highly perilous for individual investors.
Volatile returns and uneven investments
10% average return is only an average. In fact here are the actual returns for the US markets in the last 17 years:
1991 30.47%
1992 7.62%
1993 10.08%
1994 1.32%
1995 37.58%
1996 22.96%
1997 33.36%
1998 28.58%
1999 21.04%
2000 -9.10%
2001 -11.89%
2002 -22.10%
2003 28.69%
2004 10.88%
2005 4.91%
2006 15.79%
2007 5.49%
2008 -35%
And of course, to date, the US market is about -35% for the year, which wipes out a significant amount of return. However, an investment made in 1991 would still have turned out pretty well. But here is the first problem: people invest every year in their private pensions. Unless you get a huge inheritance and invest it all when you're young, you will never take full advantage of compounding returns. In fact, like most people, they make more money as their career progresses, so if you just happen to be unlucky enough to work in a 30-40 year window where all the high returns happen towards the beginning and all the poor returns happen when you are able to save the most, you can end up in negative territory easily
I still believe in free market principles as long as there is transparency. However, as you can see from this real life example, there is a pragmatic case for a minimal level of defined benefit pension insurance (i.e. public pension).
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