Monday, September 07, 2009
How Pathetic Returns Can Bring You Joy (or, Why I Don't Listen to My Wife)
So I'm talking to my wife the other day about this new trading system I'm working on and, feeling pretty pleased with myself, mention that it shows a historical return on the total trading account balance of 4% a month.
You know what she says?
"Four percent?!... that's pathetic!"
Always ready with a snappy comeback, I reply, "Huh?!"
"Four percent?!", she says, "That's like... bank interest!!"
"No, no, Sweetie", I say. "Not four percent a year... four percent a MONTH."
"So?! It's still only four percent!"
Then, as I stare at her blankly, she goes on to ask why - if this trading stuff is so great - we don't just draw our profits out of our trading account and live on them instead of working for a living.
"But Sweetie", I stammer, "that would be crazy. Then we'd lose the benefits of compounding."
Something about the way she snorted and rolled her eyes left me thinking she wasn't convinced.
Now granted, my wife may not be the greatest mathematical mind of our time, but I don't think she's alone in underestimating the amazing power of compounding returns.
I, myself, have frequently been FLABBERGASTED by the difference compounding can make.
It has been claimed that no less of a mind than Albert Einstein once referred to compound interest as "the eighth wonder of the world".
What's so amazing about compound interest? Let's take a simple example and see:
Let's suppose all we have to invest is a measly thousand bucks. That's it. One lousy grand.
But never fear - my wife helpfully assists us in locating a "bank" that will pay us 4% a month on our account balance (that's a MONTH, mind you!) Oh, and while we're at it, we may as well insist that this bank doesn't charge any kind of fees - I'm sure that won't be a problem :-)
So we stick our thousand smackers in this "bank", and lo and behold, each and every month we make 4%, or $40, on our investment.
Following my beloved's sage advice, we promptly draw our forty clams out of our account each month and blow it on living the high life.
In fact, we're having such a great time living high on the hog with our monthly forty bucks that we keep doing the same thing month after month for let's say... thirty years.
At this point, worn out with all the non-stop partying, we take a look back and see how we've done with our investment.
Let's see... we've drawn out $40 a month, for 12 months a year, over 30 years. That's 40 x 12 x 30 = $14,400. Woo-hoo!
But wait... It gets even better! We still have our original thousand bucks sitting in our account. So actually we've managed to turn $1,000 into $15,400.
And just in time for the retirement home.
Let's see if we can do a little better...
Let's start with the exact same scenario... We've got a mere thousand bucks to invest, and a "bank" that pays a lousy 4% a month on the balance, and of course, no fees.
But this time, we recklessly ignore the wife's wisdom (don't try this at home!), and foolishly leave our first month's forty bucks sitting in our account gathering dust. We do this month after month for the very same thirty years, never drawing out a penny, each month earning a "pathetic" 4% on the account balance. (No, I love her, really I do.)
Now I'm going to ask you. How much do you think we will have in our account at the end of the thirty years?
Go on. Guess.
I dare you.
Take a stab.
... Then click on the piggybank to see the answer.
By the way, that Einstein "eighth wonder" quote is widely disputed, and he probably never said it.
But he should have!