Don’t Play it Too Safe
This article, originally written in April 2005, is republished with minor editing.
Two brothers inherited $100,000 each. Larry put his money in an account that earned an average of 4% per year. When he retired 25 years later, he had $266,584. Unfortunately inflation had reduced his purchasing power such that he was not much further ahead 25 years later.
His brother, John, put his money in an account that earned an average of 7% per year, with some fluctuation from year to year. When John retired 25 years later, he had $542,743.
John had earned $276,159 more than his brother simply by earning 7% per year versus 4%.
This hypothetical story shows what a difference there is between 4% and 7% compounded annually over time. Taxes were not considered.
With people living longer, retiring earlier, and fewer employer pension plans, growth on savings has become even more important than in the past.
In order to avoid the risk of losing any money, many people put their savings into bank accounts that pay very little interest, with no potential of earning more. Thus their money grows at a very slow rate. This is one of the biggest mistakes retirees make: under-estimating inflation risk.
The bottom line is, most people cannot save enough to have a comfortable retirement, without a good rate of return on their savings. They need growth. They need growth that will outpace inflation to ensure their purchasing power is not eroded over time.
What a difference a few extra percentage points of return can make. Larry was so concerned about losing a portion of his $100,000, he lost $276,159 over time by playing it too safe. In so doing, he was the real loser.