The real latte factor

I read today that if I give up my daily latte, I can become a multimillionaire.  Really!?

[David] Bach says a 25 year old who starts putting away $10 a day could have almost $2 million by age 65 in an investment earning 10 percent a year. (From 1975 to 2018 a diversified portfolio of 60-percent stocks and 40-percent bonds has had an annualized return of 9.9 percent, says Bach.)

Ok, Sparky, a couple of problems here:

• First of all inflation.   $100 in 1975 was worth $500 40 years later.  So that $2 million ending balance is actually $400,000 in real terms.

• Second, historical returns are very unlikely to be achieved.  The time period picked started with low stock market valuations and very high interest rates.  So stocks and bonds went way up.  If you pick up a copy of Stocks, Bonds, Bills, and Inflation (an annual read I find transfixing) you'll find that this is actually the only historical period where such fine results were achieved in both stocks and bonds.

Over time the expected return of an investment portfolio is its yield plus the growth rate of cash flows, plus or minus the change in valuation.  

So, buy yourself a 30 year Treasury bond with a yield of 2.57%.  Deduct likely inflation of 2% (the Fed's target rate), and your real return on the bond piece of your portfolio will be 0.57%.  For stocks, the long-term real growth trend has been 3-4%, and you have a yield of about 2%.  Deducting inflation we get an expected real return of (generously) 4%.  So for the 60-40 portfolio described, expected returns from here (assuming no nuclear or global warming catastrophe) might be (0.6 * 4%) + (0.4 * 0.57%), or about 2.4% per year.  

Well, what about the change in valuation?  Bonds can rise in value if rates fall, and we've all seen stocks go up faster than fundamental would warrant.  Sure, but rates are very low and stock valuations are high (though not extreme) so it's unlikely a favorable change in valuation would help you much as it did in the 80s and 90s.  And remember, he's selling on you returns achieved over a long period - the chances that period ends at the peak of a market bubble are...not high.  So for our purposes I'm estimated the change in valuation at zero.  A prolonged slowdown or accelerating inflation would likely turn that estimate negative.

So, plugging the numbers into a spreadsheet, if I give up a couple lattes a day, I'll save $3,650 per year, and in thirty years I'll have $172,765, which I admit is nice except I'll be dead then and won't be able to spend it.

You see, the final dirty trick here is that the miracle of compounding doesn't really kick in until the third or fourth decade.  After ten years of Spartan denial I would have just $40,706, enough to buy a nice car like, say, a Chevy Bolt:

Robin Leach is, alas, unavailable for comment

Now I wouldn't mind having a new car when I'm 67, but actually - given the choice of a nice new car then, or a delicious morning beverage every single day until then (and on into an uncertain future), I'll take the beverage thank you very much.

Oh, one other thing - most people will engage an investment advisor who will, by hook or by crook, take 1-2% off the top each year, significantly slowing down all this magical compounding.

So, no, a few simple small sacrifices and a programmatic savings program will not make you immensely wealthy some day.  As always you can consume your wealth or defer it.  Choose a sensible balance - of course you should provide for your future - but there is something to be said for enjoying a nice cup of coffee in a quiet moment.  You should do some of that, too.

I prefer cappuccino, but the logic works the same

Finish Rich with the 'Latte Factor' - (link)