Some Perspective on Returns
By Brad Thomason, CPA
Very early in my career I had a conversation with a prospective client, which at the time, felt quite surreal.
This was back in my broker/dealer days. He came to my office because he had some money that he wanted to invest in something. We discussed several possibilities. But each time I laid out an option, all he wanted to know was the minimum amount he could invest, and how quickly he would get his money back.
When you are young you assume that people who are older than you are know what you know, plus presumably some extra things that you don’t yet know. But the perspective is very much, “I’m only x years old and I know this, so I’m sure you must know it too since you are older.”
As I am no longer a young person on much of anyone’s scale, I now know that isn’t the case. Wisdom may come with age, but it’s not a given that knowledge does too.
What I of course knew was that investment returns come from having capital deployed. Wanting to minimize the amount of capital and/or the amount of time it was deployed would work against the prospects for making any sort of meaningful returns. To earn the most money you needed to send that capital out and leave it alone to do its thing.
Since that first experience I have had similar conversations more times than I can recall. Because it has happened many times now, it is no longer surreal when it occurs. Though I admit, it still seems to me like the whole thing is a pretty basic principle that one would think more people would pay attention to.
It may stem from the fact that the attention almost always seems to first be focused on the rate of return. It doesn’t take any insight nor imagination to see why someone would want a higher rate than a lower rate. But what sometimes get lost when rates are the focus and the other elements are forgotten, is that when you have consistent deployment over a period of many years working for you, seemingly small changes to rate can make a bigger-than-expected difference.
Most investors don’t get particularly excited over an 8% return. Sure, it beats a lot of what’s out there, and there are many instances when a person switching to such an investment would start making more money. But exciting? The kind of stuff you go bragging to your pals about? Not so much.
Yet a sustained 8%, even as compared to something else at 7%, can produce meaningful effects. If a 55 year old starts an investment with $250,000, it will grow to almost $690,000 by the age of 70 if the compounded return is 7%. But it will grow to more than $790,000 if it’s 8%, just one point higher.
If we expand out to a twenty-year time frame the difference is even more pronounced: $965,000 for 7%, versus $1,165,000 for 8%. Nearly $200,000 more.
The knee jerk is often to want your money back quickly, and to only be interested in big, flashy-sounding returns. Yet most success stories are built on an understanding of cumulative returns, over a sustained period, with merely-solid returns (i.e. 5% to 8%, in a lot of instances) driving the effort.
I hesitate to go so far as to say that there’s a right way and a wrong way to do all of this. Doing so might imply a degree of judgmentalism and/or unfounded opinion that I’m not sure is really the consultant’s prerogative to assert. It is your money, after all. I think such a statement also runs the risk of implying that if you don’t follow one precise recipe, you’ll have blown your only chance of getting the win. Which is simply not true.
Nonetheless, there are mechanical realities to the way money behaves and grows, just as surely as there are set understandings of how water flows down hillsides and what’s required to build a bridge capable of holding up a truck. If you ignore these factors, you are unlikely to get the results you are after. Or if you don’t know them in the first place.
Send it out; leave it out; don’t let the quest for great returns get in the way of earning good returns; time is your friend if you have something for it to work with (i.e. principal), even if the returns aren’t eye-popping. Those are the basics. And they matter.
Smith and Jones
By Brad Thomason, CPA
Smith and Jones live on a planet in a galaxy far, far away. It costs $100 a year to live on this planet.
Smith makes $100 a year. Jones makes $200 a year.
Question: Is Jones twice as well-off as Smith?
Answer: No. Jones is infinitely more well-off than Smith.
That’s because Jones has an opportunity to build wealth, and Smith does not. The fact that Jones has a higher income than what he needs for immediate bills breaks the seal on a source of incredible economic power. The money he has above and beyond what gets depleted in the same period that it’s earned, is money of a completely different type. That money has productive capacity – the ability to replicate and multiply itself by way of investment returns.
In time, the amount of money that Jones possesses will come to far exceed the simple sum of each year’s extra portion. The extra $100 he received in the first year may come to be $500 or $600 at some point out in the future, as the result of compounding returns on the original seed amount. Maybe more. Maybe a lot more. And the excess from each successive year is a candidate for getting on the same path to expansion.
One day in the future Jones could have a pile of money that he will never outlive, even if he quits his job. Smith, on the other hand, will not be able to afford such an option. He’ll have to keep matching current income to current bills.
Sometimes we get caught up in very complicated lines of thought when we are engaged in managing our finances. But many of the most important things to remember are also the most basic. Having some investment capital in the first place is the pebble in the pond which sets up all the rings which will grow in the future. For most of us, that capital will come from not spending everything that we earn.
Entry to the club really is that simple. Or maybe straight-forward would be a better term. Because sometimes it is difficult to end up with a little bit of surplus each year. But there’s no mystery about how you become an investor and start the process of building wealth, even if doing it may require some effort, or even discomfort, in another part of your life.
Note also that this dynamic persists all throughout your working years. At any point along the way that you make money which doesn’t get immediately spent, you get to tap into this power source over and over again, in ways that are cumulative at an ever-accelerating rate.
Which, if you stop and think about it for a minute, is pretty dang cool.
Our planet is a little more complicated than the one that Smith and Jones live on. The possibilities for what a person might make, and the range of things that a person might spend that money on, are far more varied. But the financial underpinnings are the same. If you can find a way to turn some of what you earn into productive capacity, you are on the road to being more like Jones. Which, to me, seems a lot better than being more like Smith.
Older blogs (2015-2017)