STRATEGY SHEET
March 2000
The Most Important
Investment Parameter
© Talbot Stevens
To be a successful investor, it is important to understand the laws that govern investment growth. I'm not talking about the legal world of courts and lawyers, but the mathematical laws of how money grows.
Albert Einstein described compound growth as the eighth wonder of the world.
Most people don't like math and won't benefit from knowing the exact exponential equation defining compound growth.
All that is important to know is the parameters involved and which ones are most significant. Understanding this allows us to focus on the most important factors that we can control.
The value of an ongoing investment plan at any time in the future depends on the three key parameters of time, returns, and dollars contributed.
Naturally, increasing any of these parameters will increase the future value of your investments. But one parameter is much more important than the others.
Let's illustrate with an example. Our reference case will be investing $2,000 a year for 20 years averaging 8% returns. $2,000 a year times 20 years is $40,000, but due to the magic of compounding, this actually grows to a little less than $100,000.
If you increase the dollars invested by 25%, the retirement fund increases by exactly 25%, as expected. Increasing returns by the same 25%, from 8% to 10%, produces $126,000, a 27% increase from our reference case.
But the significant benefit occurs when you increase the time period by 25%. Investing $2,000 a year at 8% for 25 years instead of 20 produces $158,000, a 60% increase.
To summarize, a 25% increase in returns produces a negligibly higher 27% improvement, while a 25% increase in the time period increases your retirement fund by 60%. Clearly, time is the most important parameter in investment success.
Obviously, you can't change history. In other words, if you are 20 years from retirement, you can't start 5 years ago to turn it into 25. What we can control, however, is to not start 5 years from now.
If you are 20 years from your target, the best thing to do is to take advantage of all 20 of those years to let compounding work its magic. Human nature being what it is, we tend to procrastinate and ignore the issue and its financial impact, letting the potential 20 year period decrease to 18, 15, etc.
With savings rates in North America near all-time lows, too many people are thinking that the future will take care of itself.
If you want to live securely the last 20 to 40 years of your life, independent of the government, get time working for you, starting today.
Set up a monthly "pay yourself first" investment program now, and stick to it. An even better approach is to start a forced savings plan with an investment loan to catch-up RRSPs, or to boost unregistered investments.