I read an advertisement which explained the "magic of compound interest".

According to this ad, young people can use compound interest to their advantage and start their retirement in 40 years or so with around $400,000.

Wouldn't that be great! Or would it?

The ad compares two different saving strategies of two 21-year-olds each preparing his "nest egg" for when he is 65. Both young men get a return (it's assumed for the sake of the example) of 8% per annum.

The first young man contributes $2,000 per year for ten years. Then he contributes no more but just lets it grow. At age 31 he has contributed $20,000. Due to the 8% compound interest he will actually have $31,000 when he in 31. When he retires this will have grown to $428,000.

Sounds fantastic doesn't it!

The second 21-year-old delays for ten years and starts saving when he in 31. His strategy is to add $2,000 per year until he in 65. This young man will have invested 35 x $2,000 = $70,000 when he in 65. With his hypothetical 8% interest per year he reaches a total of $345,000 at 65.

The first strategy, the ad informs us, is obviously better – less investment but a greater return. Both strategies provide a fantastic "nest egg" but the first strategy provides a bigger "nest egg" at smaller cost.

It sounds great doesn't it?  Really magical!

Hey wait a minute! What about inflation? What if inflation has a "magic" which destroys the other "magic"?

Let's assume the two young men started their strategies in 1993. In Australia inflation has varied in recent decades from about 2% to 20%. Lot's assume that in the future the average annual inflation rate will be 8%. This means that a dollar loses 8% of its value each year. If you have $100 in 1993 and leave them under your pillow then their value a year later would, in 1993 dollars, be $92. Another year under the pillow and a further 8% loss in value would leave your $100 able to buy only as much as $84.64 did two years earlier. And so on.

By my calculation the $428,000 which the first strategist will have in 44 years time will have the purchasing power which $10,900 had in 1993. He has not done particularly well at all if we allow for 8% inflation!

The second young man who starts saving in ten years time is actually saving dollars which in 1993 terms (if we still assume 8% inflation rates) have a value of 0.92 to the tenth power = 43 cents. Although he gets a lot less at 65 he has also lost a lot less because his dollars are of less value. Indeed his final investments when he reaches his 60s will be almost worthless. 0.92 to the 40th power reveals that a dollar in 40 years time, if inflation averages 8%, will be worth only 3.5 cents in 1993 values.

If we converted all the invested lots of $2,000 in the above story and all the other sums of money to 1993 values we would find that both of the inventors did approximately as well as each other.

However, both investors will actually get back much less than they invested. With interest and inflation in my example both at 8% it might seem that they should balance each other out resulting in no final loss and no final gain. But they don't balance out. The main reason for getting less return than invested is the cost of establishment fees, maintenance fees and government charges on investments.

There is another reason why interest and inflation do not balance each other out even when both are at 8%.

Consider: 8% interest on $100 gives $108 if interest is paid annually.  Reduce the $108 by the 8% inflation rate to get the value of your $108 in terms of the previous year's dollars: 108 x .92 = $99.36.  In effect you invested $100 and got back $99.36 even though the inflation and interest rates equalled each other!  This particular loss can be offset if interest is calculated daily rather than annually.

Do you want to do better than the two hypothetical young men?

What you need is an investment scheme which guarantees a set percentage return above the inflation rate. If inflation in any year were say 8% you want your return to be say 9% or 10% in that year. If the inflation rate in another year were 30% you might want a return of 32% and so on.

Such an agreement, however, you might not be able to get with any bank or insurance company.

Furthermore, you should not try to rely on this article when making investments but instead get specialist advice.

The "magic of compound interest" can be as illusory as other "magic" if you do your sums wrong!

AUSTRALIAN SKEPTICS Inc.
NSW, 2000.

October 27, 1994.

The Editor, INVESTIGATOR.

Dear Mr Stett,

The author of the article "Magical Interest", while mentioning government charges on investments, could have been more specific by pointing out that the interest would attract upwards of 25% income tax and would leave a corresponding lesser amount to compound. Further, the suggestion that an investment scheme guaranteed to return above the inflation rate would only need an extra percentage point or two is incorrect.

Taking into consideration the concomitant charges levied against the investment and given an inflation rate of 8%, the investor would have to seek a return in the vicinity of 12% to show any margin at all.

Yours sincerely,
Harry Edwards
National Secretary,
Australian Skeptics Inc.

Mr Edwards comment about my article on "Magical Interest" is correct if we assume the two hypothetical saving strategies involve payment of tax.

The strategies described precluded paying of tax on interest on a yearly basis. And who knows what rules will apply to lump sum payouts in 40 or 45 years from now?

The lesson I taught – that inflation might destroy the value of the "nest egg" despite the magic of compound interest – is even more relevant if the "nest egg" is shared with the government via taxation.

Page 47 of the same edition of INVESTIGATOR says the odds of civilization being destroyed by an asteroid are about 200 times better than an individual winning a major lottery. This of course assumes that the individual enters only one major lottery in his lifetime. If he decides to enter many lotteries the chances of him winning one of them may approximate the chances of him and civilization dying by asteroid impact.

The question of why, if he is rational, he takes seriously one possibility and not the other remains a valid question.