Few people are born understanding compound interest. As a result, some are seduced into buying things today using loans, and forgetting who really pays for their debts tomorrow.
An interest rate of 6% or 7% doesn’t sound so bad when you’re 21 and earning for the first time. But over the long-term, a life lived on credit will be very expensive and less rich than one where you live within your means.
- A £10,000 loan at 7% paid off over ten years costs £14,000
- The same loan over 30 years would cost £24,000
Sure you can get a lower loan rate than 7%, but for most of my life you could have paid a lot more, too.
The point is you spend a lot of your future income for the benefit of owning something now when you buy it via a loan, due to compound interest.
Compound consequences
Some people never do grasp how compound interest adds up over the long-term. They fail to get out of debt, and they end up in all sorts of difficulties.
However, most of us are at least bailed out by buying a house with a mortgage, which forces us to save for most of our working lives.
The average UK home has increased in real terms by 2.7% a year for the past 50 years, according to a report by Halifax a few years ago. Because of the power of compound interest, this seemingly tiny growth rate has made residential property a good investment for most homeowners.1
A minority of people also start saving into pensions early on the advice of an older family member, or even their employer. Assuming they are lucky enough to avoid being stuck in an expensive pension scheme, most early birds will again benefit from compound interest over their working lives.2
But some of us go further. We “get” compound interest the way other people get religion or vegetarianism or cross-dressing at weekends. It becomes a way of life, and an ever-present calculation.
If compound interest grabs you like this, then you start to see the whole world – certainly the world of money – in a new light.
Once you have seen the historical returns from shares – and you’re a believer – then it becomes much more difficult to splurge half a year’s salary on a new car or a fancy sofa, even if you’re paying with cash, not debt.
In your mind’s eye, you see the £3,000 you might recklessly divest yourself of at John Lewis one fine Saturday morning as the £40,000 it could become if you invest it for 30 years.
What’s wrong with sitting on old suitcases, anyway? It’s bohemian!
Warren Buffett’s Folly
If being in thrall to compound interest is a problem for you, just imagine how it feels for Warren Buffett. The world’s richest man has compounded his wealth by 20% since the early 1970s. Before that has was doing even better.
Every can of soda the notorious Coca-Cola fan swigged in the 1950s therefore cost him thousands of times as much as he paid for it, compared to if he’d put the money into his investments and had a glass of water.
Of course Buffett is well aware of this – and he was prescient about it, too.
From the excellent Buffett biography The Snowball
The Buffett’s bought their first house [in 1957]. It stood on Farnam Street, a Dutch Cape set back on a large corner lot overlooked by evergreens, next to one of Omaha’s busiest thoroughfares. While the largest house on the block, it had an unpretentious and charming air, with dormers set into the sloping shingled roof and an eyebrow window.
Warren paid $31,500, and promptly named it “Buffett’s Folly”.
In his mind $31,500 was a million dollars after compounding for a dozen years or so, because he could invest it at such an impressive rate of return. Thus, he felt as though he were spending an outrageous million dollars on the house.
Now I’d say the opportunity cost of paying cash for a charming house that you live in for the rest of your life can be filed under ‘billionaire problems.’
But the point is clear. If compound interest really grips your imagination – and it’s clear from his biography that it had Buffett in a headlock by his teens – then spending money will never be the same again.
Frugal fundamentalists
Of course few us will be the exception that proves the rule when it comes to super-investing like Buffett. We will be aiming for perhaps 5-10% from our diversified portfolios, over the long-term, depending on how optimistic we are. Some are gloomier.
For us mere mortals then, a can of Coke today isn’t going to cost our future selves a car. But if we’re saving in our 20s, it might still cost us a couple of pizzas delivered to the retirement home. Those Coca-Colas we skip will all add up.
How do we square this circle? It can only come down to personal choice, as we’ve seen in the excellent discussion among Monevator readers recently about what to sacrifice to achieve financial freedom.
For some people, saving more than the standard 10% to 15% for retirement smacks of being tight, not frugal. But for those who’ve really got the compound interest religion, almost any spending beyond housing, decent food and clothing and access to fresh air equals money wasted on fripperies.
True believers scoff at the latte factor, which is the idea that you can pay for your pension by skimping on Starbucks. Try the PG Tips factor, where you spurn expensive branded teabags for Lidl’s finest. Compound interest extremists use the teabags twice.
Clearly there’s a law of diminishing returns here. Personally I’m prepared to give up owning a sports car, but I’m not prepared to give up the occasional foreign holiday. Your mileage will vary.
Don’t be dead wrong
The other side of the equation is the iron law of mortality. As the famous economist Keynes pithily put it: “In the long run we are all dead.”
In the worst case scenario, there’s no point in giving everything up today for a future you’ll never see.
Plus all of the other cliches you hear:
- You don’t want to be the richest corpse in the graveyard.
- He who dies with the most toys still dies.
- Tomorrow you could get hit by a bus.
- Own-brand tea bags used twice taste like old socks. (Okay, I coined that one).
I’d add a few more truisms of my own.
Firstly, it’s good to plan and to stress test your calculations, but beware of spurious precision. You can’t bank on expected returns.
Forget about precise asset allocations. A cheap and well-diversified portfolio is your best bet, but every investment can fail you and in the end you can still be duffed up by sequence of returns risk.
If only we knew exactly what returns we’d get from investing and exactly when we would die, we could save and spend our money perfectly – and go on a giant bender if the prognosis isn’t so hot.
Unfortunately we don’t.
We could save for years only to die relatively young, as I saw happen to a close family member. Or we could spend like crazy and condemn our future selves to an even more difficult old age.
Or we could hedge our bets and strive for a sensible middle-ground.
Balancing your books
My own view is young people are already rich, middle-aged ones still have most of their health and non-financial wealth, so I’d rather save more today and have some extra money to splash out on a bionic Zimmerframe and luxury crumpets if I make it to my 80s.
But some things are clearly worth spending money on now.
I think memories are often overrated compared to what they cost, but I also believe that looking forward to 30 years in a bedsit is no way to live. If penury was the only way I could fund a pension, then I’d strive to boost my income. If that failed then, to be frank, I wouldn’t save at all.
The point is a little sensible spending goes a long way.
Money can’t buy you love. Just ask that world’s richest man. In 2011, Buffett touched on his former “folly”, revealing to shareholders that…
All things considered, the third best investment I ever made was the purchase of my home, though I would have made far more money had I instead rented and used the purchase money to buy stocks. (The two best investments were wedding rings.)
For the $31,500 I paid for our house, my family and I gained 52 years of terrific memories with more to come.
…although re-reading that, I’m sure I hear the muffling impact of an octogenarian’s gritted teeth.
Do you think he really means it?
(Image by James Brown)
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I believe he means it. Of course he is in a rather enviable position compared to most.
Because of his unique investing talent, he has managed to set his own life up in a way that isn’t possible for most.
– He never had to move to pursue his career.
– Never been out of a job – or even had it at risk – for the last 40 or so years.
Looking at maslow’s hierarchy of needs, he has ticked every box. That’s something most people can’t say.
From memory, even when he bought it, it was 30% or less of his total wealth. When no aspect of financial well being needs to be taken into account, then security for your family would likely be the next big thing on the list.
I don’t think there is a right answer for everyone on saving v spending
Its a dynamic equilibrium with lots of individual variables, like:
– How absolutely wealthy are you?
– How much do you like working?
– Are you likely to be able to continue working past age-40/50 in your chosen career?
– How comfortable are you with having a second/third career to fund yourself in older age?
– What is your health and history of longevity in your family?
– How much of the past do you remember from 10/20 years ago?
– How much you care about what your family/friends/neighbours think of your social status?
– How happy are you in relying on a future government or family inheritance to provide for your retirement?
Spending everything you earn on partying and holidays is a perfectly rational decision if you are wealthy already but have a congenital health defect and a perfect memory…
If you can concentrate on the big items to reduce expenditure: cars, houses, eating out (only on special occasions), school fees (ie send the little darlings to a state grammar or local comp) your 90% there. Manufacturing your own toothpaste, eating ultra cheap food, always skipping the latte and never going on holiday will just make your route to FI depressing and much harder, especially if you also have a family to raise whilst personally you are trying to achieve FI. In fact trying to “take” my family with teenage kids on this route has been the toughest part.
I agree with you about the tea bags but I recently managed to find PG Tips on special offer at the same price as supermarket own brand, so I bought a year’s supply. Come to think of it, if I use each one twice they’ll last two years!
Excellent article – thanks.
And great comments too – don’t shut em down Investor.
I’m with Jon – hit the big ticket items – like school fees.
I have three boys through the state system. The first has managed to make it into Med School, the second is doing computer science degree and third is at A level stage.
How much would that have cost me at a posh school ? £500,000 including lost investment returns?
I was sent to one – and it didn’t do me any good !
1) Redbush Tea still tastes good the second time.
2) “Few people are born understanding compound interest.” In my day we were taught simple interest and compound interest. I can’t remember when, but the need to “raise to powers” probably implies that we did that after we’d learnt to use log tables. (Remember them?)
3) What’s the point of becoming a billionaire if you’re still going to drink coca-effing-cola? Are all his tastes childish? In fact, not only childish, but bad? Surely he could at least graduate to Dandelion and Burdock, if only in private?
4) “The two best investments were wedding rings.” What an amateur: my wife made her own wedding ring.
Your compound interest point hit a spark with me.
When I was in my late teens I was on a strict budget, but probably for the wrong reasons.
I gave up various expensive tastes such as holidays in the sun and expensive clothing simply so I could afford to go to the pub at the weekend!
If only I had banked all the money, I may even be able to buy a share in berkshire hathaway!!
Dom
My favourite is the Manhattan Island purchase whereby the dutch bought Manhattan Island for $24 worth of beads. Assume that was invested at a modest 5%(nominal) interest you get:
Principle*(1+rate of increase)^number of years = 24*(1+.05)^389 = $4,196,126,573
The problem is that no-one has those kind of timescales. I think Warren Buffet has agreed to give almost all of his wealth to the Gates Foundation, and that has to be spent within 20 years of their death. So I suppose the glass of wine he didn’t consume in 1950s might be fighting poverty and disease into the 2070s.
I do sometimes find myself wishing that a Medieval/Roman ancestor of mine might have willed that one penny be held in an interest bearing trust until such time as I happen to have been born and for some obscure reason something happened triggered the trust to be passed to me.
“The problem is that no-one has those kind of timescales.” The Oxbridge colleges do. And don’t overlook “Aberdeen Harbour is both one of Europe’s most modern ports and according to the Guinness Book of Business Records – Britain’s oldest businesses. Through more than eight centuries, …”
So there you are; two different examples, both dominated by ports.
@Dave interestingly we have a rule against perpetuities explicitly to avoid that situation where a dead hand from the past reaches out across a long intercession of many lifetimes gathering power, then striking with overwhelming financial power to influence the living in centuries to come.
Noway and some of the other functional oil countries are also investing on long time scales.
I’ve posted it before but here’s an excellent article about such Methuselah Trusts from an excellent site I wish I took time to browse more:
http://www.laphamsquarterly.org/essays/trust-issues.php
People who actually read the book would know that he drank Pepsi in the 50’s 😉
@Jesper — Are you sure? In that case I’ve fallen for his post-purchasing the shares of Coke spin. 🙂 He loves to explain how he missed them for 50 years, despite knowing the products.
For my sins I’ve read The Snowball twice. All 700 odd pages!
@All — Cheers for the thoughts. I’ve meant to write about those ultra long term trusts Greg cites (and the disbursement rules) for a while, they’re really interesting.
I agree with Jon too. There’s old phrase ‘penny wise pound foolish’ which sums up the attitude of an awful lot of people whom I have known. Not on this forum of course.
As for tea, it’s loose leaf Darjeeling for me, single estate if I can get hold of it!
I’m afraid even The Investor doesn’t understand compound interest. A loan of £10,000 at 7% over 10 years becomes almost £20,000 and over 20 years would be almost £40,000.
I wanted to play golf when I retired,but out of nowhere I have stenosis myopathy,nerve damage which causes weakness pain.
health is right up there,especially 50+
Hi Cassius — Luckily I do, but perhaps my writing is less lucid. Your numbers assume the loan isn’t paid off at all over the term. But as I initially wrote, I calculate the loan “costs” almost £14,000 over ten years, because you’d typically pay down such a loan over the ten years.
Clearly I wasn’t, er, clear enough, so have tweaked copy above. Thanks for your feedback.
I like his 3 best investments. He is putting family very high on his list. I think this is part of what makes him so successful.
The Investor -> Oh.. you’ve actually aswerede my snotty comment 🙂
But yes, i am sure: “Keough had convinced him to switch from his own concotion of Pepsi dosed with cherry syrup to the newly introduced Cherry Coke. Buffet tried it and liked it. His family and friends were gobsmacked when the man famously loyal, especially to Pepsi, performed this turnaround.” Its in chapter 47 1987-1991.
This is such a brilliant article, so witty and well written. Despite being primarily an analysis of what to do with your money (if you’ve got any) I laughed out loud, pondered on my own mortality and considered alternative methods of making tea amongst many other delightfully inspired thoughts. My favourite post on Monevator, for it’s style and wit whilst conveniently expounding the fundamentals of compound interest.