Investments

Some Surprising Investment Return Math

It might surprise you to learn that when you first start investing, the return that you make is relatively unimportant. What is much more important at the early stages is the amount that you contribute annually.

It is true that if you invest a single lump sum and let it compound, then the returns in each year are equally important. That is, if you invest say $10,000 and lose 20% of that ($2,000) in the first year then this will have exactly the same impact on your final portfolio as would a 20% loss in year 10 or year 30 etc.

But realistically people do not invest a single lump sum, rather they usually begin investing at some point and then typically make an annual investments most years . Typically the amounts invested grow over time as individuals advance in their careers.

So... if you make or lose 20% that first year it would only affect your initial contribution as well as the future compounding of that initial contribution. However, if you make 20% or lose 20% in year 20, then this will affect the compounded level of your contributions that were made in each of the 20 years as well as the future compounding of each of those 20 sums. The result is that returns in later years matter a lot, while your returns in the early years will not matter much.

In the early yeas of a retirement savings plan, the annual contributions matter a lot and will tend to dwarf the impact of your returns. For example, If you begin by contributing $3000 per year a 10% gain on the first $3000 ($300) is dwarfed by the next year’s contribution of $3000. However, if you invest $3000 per year for 30 years at 10%, then in 30 years this will grow to $543,000 at which point a 10% gain ($54,300) will dwarf your $3000 annual contribution.

I calculated that a loss of 10% in year 1 (rather than gain of 10%) will affect the portfolio value in year 30 by just 2% (because it has no impact on the contributions after year 1). Meanwhile a loss of 10% in year 30 (rather than a gain of 10%) will affect the portfolio by 22%! (because it impacts the contributions from each year.

In the early years the most important thing is to make regular contributions to savings, the returns in those early years while important will tend to be dwarfed by the impacts of the annual contributions of new money.

In later years, the returns become much more important than the annual contributions. At some point if you can build up say a $500,000 portfolio, then a 10% return will be $50,000. At that point, your annual contribution may be totally dwarfed by the return on the portfolio. In fact, the portfolio could become almost self sustaining. At some point if the portfolio is very large compared to your ability to make annual contributions then it will hardly matter if you even make annual contributions anymore. If this point can be reached before retirement age then this is a very nice situation to be in.

The above analysis also leads to the conclusion that high risks can be taken in the early years. If you swing for the fences in the early years and strike out, it won’t matter that much because the contributions of subsequent years will dwarf a small initial loss.

In later years risk and reward both have a tremendous impact. On a very large portfolio of $1,000,000, a 20% loss is a huge $200,000 which for most people would be almost impossible to ever make up in annual contributions. On the other hand a gain of 20% on a $1,000,000 portfolio is also a huge $200,000. For most people the pain of losing $200,000 would be huge and it is just not worth taking big chances once a very large portfolio like $1,000,000 has been painstakingly built up. Swinging for the fences could be a huge mistake at that point.

For more insights on investing, visit Shawn Allen’s web site at InvestorsFriend.Com