It is only fitting to launch this blog with a discussion regarding Rate of Return (ROR). To do that, we will critique a video by The Money Minute titled: Becoming a Millionaire with 5 Dollars a Day – Investing 101
(https://www.youtube.com/watch?v=4whBx8unitU)
A story line in the video is about Johnnie, who is 10 years old and starts investing $5 per day. Johnnie is supposed to be a millionaire at retirement age. In order to accomplish this Johnnie invests in an S&P500 fund (Stock Market). The narrator tells us depending on the time frame sited, the S&P500 has averaged between 10 and 11% Rate of Return. With this information a 10% Rate of Return is assumed.
In order to compensate for inflation, and site the future value of the money in present terms, 3% is subtracted from each year’s return. This will provide a real growth calculation instead of nominal growth rate. The formula looks like this:
10% (Nominal Growth) – 3% (Inflation) = 7% (Real Growth)
Here is where the problem starts. We are told by the narrator, “Johnnie’s investments grow to a whopping real value of 1.08 million dollars before he retires from his career at 65.” This is stated as, fact, however, the reality is his investment likely will not grow to this amount.
Here are three points to consider :
1. Average ROR means virtually nothing. Like any average, an average Rate of Return is is the addition of all returns divided by the number of years’ returns took place. It is a mathematical calculation. This IS NOT what Johnnie would earn. He will earn what is known as an annualized return (Geometric Return). Incisic refers to it as an “Actual” Rate of Return. Actual RORs are almost always lower than Average RORs.
For illustration purposes, if we assume Johnnie earned an 8% actual ROR and subtracted 3% for inflation, relying only on the math, he would end up with under $500,000 in real dollars, less than half of what they predicted. So much for using an average Rate of Return for planning purposes.
Seeking higher Rates of Return by assuming more risk
is not necessary in an efficient financial plan.
2. It is easy to make big predictions without having some discussion regarding taxes. In this scenario is is a safe to assume that the money was in a taxable environment, as it is highly unlikely Johnnie had a 401(k) at age 10. It will also drive home the fact that taxes need to be considered in any financial planning.
We assume Johnnie netted the account, meaning he pays any tax due out of the account. The taxes have to be paid somehow, and for our purposes, netting demonstrates the impact of taxes. If the money was in a retirement account, the amount of tax owed would have to be subtracted from projections of the future account value as well.
Assuming a low income tax rate of just 20%, and the 10% ROR used in the video, Johnnie would end up with a “real” account value of just over $600,000. A far cry from the 1 million dollars. If we again assume a more realistic “actual” rate of return (8%) with the same inflation rate, the best could have is under $500,000. So much for that old saying we hear in financial planning “You will have…”
3. In this story Johnnie started his investment at 10 years old, and continues it until age 65. This represents a 55 year Compound Interest Curve (CIC). A curve of this length can be impractical and misleading. All it does is provide a false sense of hope, given the fact that traditional financial planning does not allow for long CICs. Two issues regarding the CIC should be acknowledged: the length of the curve, and the time periods where contributions to the curve are missed. When these two are considered a 55 year curve is unrealistic.
Each person is only given one Compound Interest Curve
across their lifetime, any deviation along the curve
will dramatically effect the end result.
The use of Rates of Return, ignoring how taxes must be paid, and unrealistic compound interest curve assumptions, demonstrate how traditional planning (Black Box) uses linear math to make dangerous projections.
In the video the narrator says, “Johnnie’s young and
doesn’t know much about money.”
The modern financial industry relies on people not knowing
much about money.
Incisic is designed to fix that very problem.
Financial Well-being through Sound Instruction