Where’s the snowball – why you’d better save if you want to FIRE

You don’t have to travel far into most personal finance sites before you find the obligatory compound interest post.  Even I did one back in 2012 where I was so bold as to call it The Miracle of Compound Interest.

In brief Compound Interest, sometimes also called the snowball effect, is at its most basic just interest on interest.  A trivial example.  Let’s say you have £1 and can get an investment return of 10% per annum (those were the days).  Choose that option and after a year you’d have £1.10 which is your £1 plus ‘interest’ of £0.10.  If you reinvest that for another year you’d have £1.21 which is your £1, last years interest of £0.10, this years interest of £0.10 on your £1 but also £0.01 which is interest on your £0.10 interest from last year.  Interest on interest...

So that’s the lovely theory but as someone who is now Financially Independent and so has been there, done that, got the t-shirt, what’s my view on it.  I’d now say care is needed.  Let me demonstrate with three simple examples.  Let’s go back in time to the end of 2007 where I’m going to give each of our punters seed capital of £50,000, I’m going to assume a real (after inflation) return of 4.1% (what I’ve achieved on my portfolio of trackers after expenses) and I’m going to assume their each looking for wealth of £800,000 (which is not far off what I thought I needed back then although inflation since has ensured I now need 2 commas) before packing in the day job.  From here their journeys will vary:

• TheRIT will crack on with working hard, focus on quality of life and so annually squirrel away £58,728 per annum (which is the average annual savings I’ve achieved since I’ve been on my FIRE journey, equating to a post tax Savings Rate of 82.4%) earning a real return of 4.1% per annum (my actual real annualised return thus far).  I know that will include inflation adjusted savings but please give me a little slack here as it’s not important to the point I’m trying to make today so won’t bother with inflation adjusting.
• MrAverage will also crack on with working hard but instead focuses on standard of living.  This means he can only save 5.1% of post tax earnings which has been deliberately chosen as it’s the current UK household saving ratio according to the ONS.  Like TheRIT, MrAverage achieves a real return of 4.1%.
• MissInvestingSuperstar follows in the footsteps of MrAverage but boy does she know her stuff when it comes to picking winners.  So much so that every year that she invests she manages double the return of the others and so achieves a real 8.2% per annum.  Ask yourself how many people actually achieve that and would you be prepared to back yourself to achieve that with severe disappointment many years hence if you don’t?

Click to enlarge, My after tax Savings Rate over the long term has been 82.4% 

Let’s start with MrAverage.  It actually takes him 46 years to pass the £800,000 mark with his journey looking like this:

Click to enlarge, MrAverage’s journey to £800,000

Now the interesting piece.  His growth in wealth has been achieved through savings of only 22% and investment return of 78%.  Compound Interest has done the heavy lifting allowing MrAverage to focus on consumption.  I’d nearly call that a Miracle and you can see the exponential growth visibly on the chart.  The downside of course is that in 46 years he’s an old man.

Let’s move on to TheRIT.  It actually takes him only 10 years (not far off my journey) to pass £800,000 with his journey looking like this:

Click to enlarge, MrAverage’s journey to £800,000

Look at the chart though.  There’s very little exponential growth meaning very little interest on interest.  The relatively short duration has just not allowed the snowball effect to kick in.  It also plays out in the numbers where savings has contributed 77% of wealth growth with investment return a relatively minor 23%.  This is consistent with what I’ve seen personally on my own real world journey.

Finally, onto MissInvestingSuperstar.  Even though she’s an investing wizard it still takes her 28 years to reach the £800,000:

Click to enlarge, MissInvestingSuperstar’s journey to £800,000

In her case you can really see the snowball effect with 87% of wealth growth coming from investment return.  The interesting thing is that 28 years is still a very long time and far from 10 years.

So back to the question I posed in the total of this post - Where’s the snowball?  If you’re looking to build wealth to FIRE over a very short timescale I’d bank on it not happening.  Instead you’re going to need to figure out how to save and quickly.  Then at least if we do only get ‘average market returns’ you’re still going to achieve your goals.

As always DYOR.