The unreliable magic of compound interest

Felix Salmon has been doing remarkably good work recently but this column stood out as particularly relevant:

My point is that the range of remotely sensible investment strategies for a working person is actually pretty narrow. You can’t just wave a magic asset-allocation wand and change your annualized return over a period of 35 years by 300 basis points. Frankly, you’d be doing well if you could improve it by 30 basis points. The market will return whatever the market will return and you will do a little bit worse than that, most likely.

So the way to have a comfortable retirement is not to think that by making a clever choice when it comes to stock-picking or investment strategy that you can somehow make up for the money you’re spending rather than saving. Instead, it’s to diligently save as much as you can, from as early an age as possible and simply invest it in a non-idiotic manner. The more you save, especially in your 20s and 30s, the more you’ll end up with in retirement.

Wall Street would love us to believe that the magic of compound interest gives us a free lunch; that a small amount of savings, if compounded at a high enough rate, can set us up for life. That might be true mathematically, but saving doesn’t work that way in the real world. Interest rates are low, now, and wages are growing sluggishly.

The three big drivers of big retirement accounts — sharply rising salaries, sharply rising house prices and a sharply rising stock market — are all looking very uncertain these days. So let’s not perpetuate this pipe dream that if only we can get an 8% return on our funds, everything will be fine. Because chances are we won’t. Absent that 8% return, the only way of getting to where we want to be is to simply spend less and save more.

There are two factors here: how much you save and how effectively you manage that savings. An entire industry has grown up around the second, usually based on appallingly optimistic estimates, often bordering on the fraudulent.

These financial gurus have done their best to popularize the idea that a good investment strategy was more important than how much money you put away and they've tried their hardest to avoid the unpalatable truth that there is only one aspect of our financial futures we have any real control over. Most of us can't really choose how much we'll make and we certainly can't control the performance of the market but we can decide how much of our disposable income to spend.

Spend less, save more, and ignore everything you hear on CNBC.