The miracle of compound interest is often taken as gospel. Your parents are constantly extolling its virtues. “Be sure to max out your 401k every month”, they’ll say. “Save 10% of your paycheck.” “It’s never too early to start planning for your retirement.”
Meanwhile the average savings account last year had a laughable 0.06% interest rate. What a joke. If asked you to lend me $100, and in a year I’d give you back your $100 plus a whopping 6 pennies you would justifiably laugh in my face. But we have been spoon fed since we were little that no matter how tiny the interest rate on offer, we still have to fork over the cash to our savings accounts or suffer the guilt trip.
The Real real return on investment
“But it’s not about the short term interest rates!” a thousand books in the Barnes & Noble personal finance section would argue. Even with low interest rates, over time, the miracle of compound interest adds up. Put aside just a little bit each month and in 40 years you’ll have millions.
I’m not here to pick a fight with the math. The numbers on compound interest do work and can be deceptive. It is true that if you start with a penny and double it every day for 31 days you have $21 million dollars. The fact that the math works is what makes this one of the most clever and pervasive scams of all time.
Most people are familiar with the concept of “real return on investment.” The dollar amount on your investment accounts go up each year, but inflation erodes the value of those dollars every year too. The real return on investment is basically represented by
[nominal return] – [inflation] = [real return on investment]
But there is much more to subtract than just inflation to get the real real return on investment. It’s much harder to put an exact number on these but they are nonetheless very real reductions in the real value you get back from the investment.
1) How much value can you get out of a dollar now vs when you cash out in 40 years?
I’m not talking about inflation, but the value you as a human of a certain age and at a certain point in life actually get from an inflation-adjusted dollar. With a little bit of money I can take several months off and backpack Southeast Asia. I can sleep in an un-airconditioned bungalow and hitchhike on the back of a stranger’s motorbike.
Getting the same amount of value when your golf cart-bound and can only stay in hotels with your particular brand of posturpedic bedding is going to cost a ton more. Sure you can be young at heart, but it’s a fact that adventure just gets more expensive after a lifetime of acclimating to various middle class creature comforts. Even at 29 it is starting to cost more money every time I do awesome things as I gradually adjust to greater levels of comfort.
Just work your job, scrape out some portion of your salary (which on average has actually decreased in real terms since 2008) and give it over to a bank. Do this for your whole adult life and then get back a lump sum when your old and can’t have nearly as much fun with it.
2) What if you die before you get there? Our pathological denial of the probability of our own mortality could fill volumes, but it is worth considering, if only briefly, how much good that retirement account is going to do you if you get hit by a bus.
3) But most importantly, and less morbidly, it’s worth carefully considering the opportunity cost, other things that you could do with the money that you can’t do if you put it in a savings account. We’ll look at that next.
What better things could you be doing with that money?
The truth is there’s never been a better time to spend it like you got it and invest in things other than investments.
I believe in skin in the game, so for each of these I’ll add how I personally am putting my money, my time or my energy where my mouth is. For starters, I’m 28 years old. I have essentially no retirement planning or long-term investment accounts at all. I have 6 months of (first world) living expenses in cash and a portfolio of other assets that I’ll describe below.
Here are some ideas besides your 401k to consider:
Invest in yourself.
This is the easiest one by far and the most compelling. Job security is eroding fast, software is eating jobs and middle class salaried positions are getting sliced up by the sharing economy.
So many of my friends these days, burned out on their current careers, realize only too late that their only economic value is hyper-specialization in their particular field, or worse their specific company. None of the skills and experience translates to any other job setting or something they could do on their own terms.
One of the best things you can do for your economic prospects (and mental health) is spend money on yourself to learn a rare and valuable skill or craft. Something that generates value that people will pay for all on its own, outside of a big corporate context. It’s never been easier to build a “side hustle” consulting business, or a product that generates a bit of passive income.
Skin the game: Over the last three years I invested most of my savings in myself. As a result I have skill sets in web development, startup marketing and cleantech that let me easily charge $100/hr, or much more, for consulting work. All of which I can do remotely from parts of the world with a dramatically lower cost of living. I recently flew to Bali and Thailand for two months. I worked relatively normal hours from the beach and came out $6,000 ahead even after trans-Pacific flights. After launching a number of failed products, I built a small software product that is a great source of passive income for me. I wrote a detailed post about building Storemapper here.
Take a productive vacation.
Americans are on average not even taking their paltry two weeks vacation these days leaving them burned out and unproductive. And not nearly enough are taking a few months off every few years and this is a huge missed opportunity. Working 40, 60, 80 hours a week takes up nearly all of your bandwidth and makes it very difficult to focus on large projects. Building a craft or business doesn’t take a lot of money these days but in some cases it can take a lot of time and sweat. Even if you’re not building a business, taking a long period of time off to work on your career trajectory, renew yourself or try a purely creative project can be a great use of cash.
Skin the game: For my part I have equity ownership in several businesses worth several hundred thousand dollars. Sure ownership in a business is not liquid money, but I’m more likely to see a cash return before you can dip in to your 401k. There are lots of stories of dogged entrepreneurs building businesses on nights and weekend while working a full-time job but I honestly couldn’t do it. The only way I was to get any of these off the ground was quitting my job and burning through a bit of savings to work on them full-time. It’s risker for sure and I don’t recommend it in all cases, but it can be a better use of savings than 0.06%.
Now that we all have credit cards, nobody borrows money from each other. Make a commitment to claw back a portion of your retirement savings to invest in a local small business and actively reach out to see if you can help. I guarantee every single independent small business you frequent is in need of some kind of financing. Even as the interest on savings accounts has evaporated, banks are hammering small businesses, refusing to lend or jacking up rates. Cool startups like Able are building a network to help you invest in small businesses you love but there’s no need to wait for them to come your town. Reach out to your favorite café or bookstore or craftsman and see if you can arrange a private loan. As a customer they are more likely to pay you back than a faceless corporation and there is almost certainly an interest rate that’s a better deal for both parties.
- I also have a small peer lending portfolio on Lending Club and Prosper. These loans go directly to individuals and small businesses and often displace usurious credit card rates. As a result I earn 8-10% on the investment and the borrower lowers their cost of capital by cutting out a whole host of middlemen.
Or just spend it (on experiences)!
Buy a once in a lifetime experience. Travel, go skydiving, spend a weekend in nature, take a cooking class, support a local artist.
What’s not included.
By no means am I advocating investing less money in retirement and buying more crap. This list does not include buying a bigger TV, a newer car, new furniture or whatever else kids are buying these days. I have absolutely no evidence to support this, but I believe that spending money on meaningful experiences and self-improvement precludes the need to accumulate to blow money on junk you don’t need. It’s a positive feedback loop in direct opposition to the negative spiral of meaningless accumulation.
I’m not going to sit here and brag about my personal finance situation. I put a lot of costs on credit cards while I taught myself web development and bootstrapped several startup businesses.
But a bit of research shows that had I stayed in a salaried job and saved the “appropriate” amount of my income I would have about $50-60k in a retirement account by now. I genuinely don’t believe I could have built any of my businesses while holding down a full-time job and I certainly wouldn’t trade those assets and skills for triple that amount sitting in a 401k.
But America has a negative savings rate, shouldn’t we be saving more?!
Well yes and no. I would argue that most of what I’m describing is not “spending”, but competing and more concrete ways to invest in yourself rather than in the miracle of compound interest. Particularly young people are paid less than their worth, feel unfulfilled and trapped in their work. They feel more and more disillusioned by the story of a comfy retirement but don’t see a viable alternative. Easy credit and emotional malaise lead us to get short-term dopamine hits by buying too much shit, and worse taking on long-term liabilities like a mortgage and car payments. Taking some money to invest in yourself gives you more avenues for fulfilling work. Investing in experiences makes you less likely to buy junk you don’t need. And keeping overhead low makes all of the above take less time and money.
It’s a trap!
Here’s the real kicker. All this is not just a bad deal but an enormous scam.
We talk about “my bank gives me a good/bad interest rate on my money” but that’s not what’s happening. You are actually lending your cash to the bank to go and do banking stuff with it. You’re lending it out a really crappy rate, basically free. Your cash then goes straight onto the balance street of JP Morgan et al so they can write more credit default swaps and do more insane things… with YOUR MONEY. Your savings account is subsidizing and funding Wall Street.
All the massive wealth generated by startups, your retirement account doesn’t have access to any of that. By the time the you can get involved in the next Facebook, there have been twelve rounds of VC and PE funds pushing up the valuation to astronomical levels, each one paying out the previous guys until finally at the IPO, institutional investors can use your cash and your pensions to be the last fool in, paying the most inflated possible price of anyone in the game.
I’m not saying this is a conspiracy, but the returns from saving for retirement are getting lower, crappier and less certain every year, but we have been trained that there are no real alternatives if we want to do the right thing.
But there is an alternative, invest more in yourself.