Quick – find the common trait: zero-to-sixty; 100 meter dash; Nathan’s hot dog contest.
It’s speed, baby.
More than any other quality, speed seems to fascinate us big apes. How long did it take you to drive here? What’s your 40 time? Can you make it go faster?
It’s no surprise that our fascination with physical speed has found its way into financial matters.
We compare investment vehicles on the basis of their yields or rates of return: We know 9% is better than 3%, all else equal. We sense intuitively that the 9% gets us where we want to be faster, so we prefer it. And we’re even inclined to go so far as to say it’s 3 times better.
But there’s a problem with viewing investment returns this way. It makes differences in rates of return seem smaller than they really are – and, as a consequence, makes allocation decisions appear to be relatively inconsequential when they’re really anything but.
In fact, with a couple of minutes and a snazzy spreadsheet, you can figure out that a 9% annualized return is really more like 6 to 9 times better than a 3% annualized return for most investors.
All of which is to say that comparing annualized rates of return isn’t as straightforward as we all might like, just because of the cumulative magic of compounding.
Fear not, though. There’s a simple way to compare the true speed of investment returns that can be done painlessly and quickly, allowing you to compare returns faster than Usain Bolt can lace up his Pumas.
Which helps us double our investment dollars as quickly as possible.
For long-term investments, what we care about – more than the nominal interest rate – is how long it’ll take us to see our money really grow.
How long our funds require to double is a handy benchmark for this kind of inquiry. It’s a standardized “distance” – like 100 meters – that allows us to compare the true speed of investment vehicles’ work on our behalf.
A 9% annualized return doubles your dough in about 8 years. The 3% slug takes its time, giving you 2x after more like 24 years.
“Hey FL,” you say, “8 years is 3 times faster than 24 years! A 9% return really is only 3 times better than a 3% return!”
Viewed this way, you’re right. And you always will be. Constant rates of return produce constant times-to-double.
But we can view things a little bit differently (and still correctly) in such way that makes the effect of compounding more visible – and helps us make better investment decisions.
After 24 years, once your 3% investment has finally reached double the initial principal value, your 9% investment will be worth roughly 4 times its initial principal. We’re left with returns net of principal almost 7 times greater with the 9% investment.
A typical investor’s 20 to 30 year long-run horizon means total net returns in the range of around 6 to 9 times greater would be obtained with the 9% investment.
“That’s just math-y math, FL,” you say. “I know how compounding works. And, anyway, I’m always after the best yields I can get, so you’re not telling me anything I don’t already know.”
Fair enough. But here’s the thing.
In the real world, when we’re out dealing with our investments, we’re much more likely to consider only the headline return rates than we are to shrewdly calculate the true compounding effects of differential returns.
In part, it’s because we’re inundated with information everywhere we turn – we need and crave simplicity, so we use simple metrics when we can.
And we do so even when it’s to our own detriment.
This principle is a core part of the behavioral economics underpinning things like the “paradox of choice.” In theory, more options should make us better off; more information should leave us more, well, informed. In practice, we tune a lot of it out. We go with headlines. We sometimes lose out by making sub-optimal choices simply because we don’t have a simple way to discern what really matters.
When we see one investment yielding 8.6% and another offering 8.1%, we’re inclined to shrug our Superman traps and mumble: “’Bout the same.” And over a single year, that’s totally right.
But over a 20 year investing horizon, even that one-half-of-one-percent difference is worth about 12% more in total returns.
A 1-percentage point difference is worth 24% more in total returns over 20 years.
And so on.
Even savvy investors lazily give up huge amounts of free cash because differences in rates between two investments seem small but really aren’t.
Don’t believe me?
Take your checking account, for instance. Do you know what it yields right now? If you’re getting anything north of 0.1%, you’re pretty much crushing the U.S. average (which is around 0.06%).
Under many circumstances, were I to tell you that you could get 10 to 17 times the annual rate of return on your little doughy soldiers, I’d also be saying you’d have to suck up a bunch more risk.
The differential in returns between a 0.1% rate (or a 0.06% rate) and a 1.0% rate after just 5 years is pretty serious on even modest accounts. And it takes basically zero effort (and absolutely zero additional risk) to set up a high-yielding account to house your slush funds and cash. Is that simple enough?
Which brings us back to measuring the speed of our investment returns. A simple way, that is, to measure speed.
A handy species of mental shortcuts is known variously as the Rule of 72 or the Rule of 70. Either 72 or 70 works well for purposes of comparing returns’ times to double.
The basic idea is that dividing 72 (or 70) by the annualized rate of return of an investment gives you the approximate number of years that investment will need to double.
An 8% rate of return needs about 9 years: take 72 and divide it by 8 to get 9. When the more spreadsheet-y calculation is done, it tells us the actual time needed to double is just over 9 years.
The Rule of 70 works a little better than the Rule of 72 for lower interest rates. If the interest rate is 7% or less, dividing 70 by the rate of return will provide slightly more accuracy.
Just going through the quick mental labor of this simple calculation will save you from thinking two similar-seeming nominal rates are really as similar as they first appear.
A 9% rate doesn’t seem like it’s much different from an 8% rate, but it doubles our money a year faster.
The simplicity of all this really is its good and its bad.
For sophisticated Luchadores, this kind of thing seems beneath us. Yet it also saves us from some of the persistent irrational behaviors that plague investors – like giving up 10x to 17x returns on our cash yields because we don’t think that little bit makes much difference. It does. At least Goldman Sachs thinks so. So, simplistic or not, it’s still worthwhile.
Moving beyond the simple mechanics, the very real benefits of this sort of thinking include:
Forcing us to take a long-term view when we contemplate investments. It’s too easy to think in annual increments when we only view the headline x% rate. This is especially troublesome since, most of the time, our investments are for longer stretches than one year.
Requiring that we truly consider the “speed” of our investment vehicles in a way that impacts our bottom line. We know intuitively that a 100 meter dash time of 10 seconds is pretty damn fast. When Usain Bolt does it in under 9 seconds, it seems inhuman. Using simple Rule of 72 (or 70) calcs regularly helps us develop this same sort of intuition about investments.
Ensuring we don’t take for granted – without question – the impact of holding funds in slow-growth accounts or assets. Improperly allocating a portfolio by over-weighting slow-growers is lethal to long-term wealth. That 0.06%-yielding account, for instance, really is – at least – 17 times worse than the 1%-yielding account. Same risk. Profoundly different return.
A recent FL post tossed out some real rates of return observed across various asset classes. Those returns can be instructive in the value of this time-to-double concept. The graph from that post is replicated here for your voyeuristic indulgence.
Looking at the chart gives you the impression that, although some asset types did better than others, so long as you held any you’d have done all right. After all, you’d have beaten inflation even if you’d only held gold. That can’t be so bad, right?
It’s like most weathered financial advisors will tell you: Some clients don’t care about lagging the indexes as long as their accounts are positive on the year. Those same clients don’t care if they’ve beaten the indexes if they’ve lost money during the year; they’re still pissed. They want a positive nominal gain, no matter how low. Then, and only then, they’re happy.
But those clients are missing the point. Nominal gains don’t really matter that much. Even real returns are only a secondary consideration. What we really care about is something like our “opportunity cost of capital“: What returns (for a given level of risk) could we achieve with proper allocation?
The following graph shows how many years each asset type needs to double in value. The analysis uses average real returns – those after accounting for inflation – so actual time to doubling in nominal terms would be shorter for each asset.
Still think you should buy all that gold?
By the time gold would have doubled in value, a $100 investment in the S&P 500 or in REITs would be worth $3k – registering a gain of around 30 times the initial sum. That 30-times return can be thought of as the opportunity cost of holding slow-growth gold as an investment.
Which illustrates how, in investing, it’s a lack of speed that kills.
I keep most of my cash holdings in a high-yield online savings account. This account acts as the conduit among my primary checking, my P2P accounts and my foreign exchange accounts. So it not only gives great yield, it also serves an important functional purpose in my financial management.
It took me roughly 20 minutes to set up and get funded when I initially did this several years ago. For that 20 minutes, I figure it’s netted me an extra $1,000 or so in passive interest (above what I’d have gotten with a lower-yielding account). Which makes my hourly return on that effort about $3k an hour. That’s some fast cash.
Luchadores, are you moved to get your cash into a high-yield account, or is it not worth the trouble? If you’re already in one, which did you choose and why?
Theme by MyThemeShop.
Unless you've been living in a cave and receiving FinanciaLibre updates solely by smoke signal and carrier pigeon, you already know what this is going to say. FinanciaLibre is a blog. On the Internet. It can't be trusted to provide answers to all life's troubles. It won't un-click the buttons on your keyboard or cellphone when you're making a ridiculous error. It's only here to entertain, provoke, motivate and, from time to time, inform. You're the captain of your own financial dinghy. Not FinanciaLibre. FinanciaLibre does not provide financial advice, legal advice or medical advice. FinanciaLibre is not a certified public anything. It's not a religion. It's not even a real word. Your decisions, actions, victories and losses are your own. FinanciaLibre's not responsible for anything you say, do or eat. Own your decisions, Luchadores.