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Chasing the mythical 8% return
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Tess Vigeland: So basically what we're saying is, you can't count on anything when it comes to investing. And that applies even to some of the most common conventional wisdom out there.
Commentator Chris Farrell wants you to think about one number in particular.
Chris Farrell: We've all heard some version of the 8-percent line: If you save $100 a month at 8 percent over the next 40 years, you'll be worth about $1.4 million.
But there are a few problems with that calculation.
For one thing, the 8-percent number doesn't take inflation into account. Inflation simply means a dollar today is worth less tomorrow. So, let's say inflation runs around 2.5 percent -- a reasonable guesstimate. After taking inflation into account, your 8-percent return is really 5.5 percent. Instead of being a millionaire, you'll be worth several hundred thousand dollars. Not bad, but not a million bucks either. And who's getting an 8-percent return on their money these days anyway?
Not the diversified investor, that's for sure. Diversification means that while you've got some risky investments in there that might get you 8 percent, you've got some safe stuff, too. And the safe stuff will lower your potential return.
Finally, there's the timing. Investment plans that tout high yields are based on an average return over time. You're heard the one about the statistician who drowns in eight feet of water while crossing a river. His last words: "But it's only three feet deep on average!"
Investors run the same risk. You could live your whole life getting a great return, and then, just as you're about to retire, the market collapses, wiping out all of your gains out completely. That's what happened to a whole generation of investors when Lehman Brothers collapsed in 2008. And it could happen to you, too.
So don't believe the 8-percent lie. Instead, save your money. Sure, buy some risky stocks. But sock the rest away in safe places, like Treasury bills and bank accounts protected by the FDIC. This way your money will grow a little more than inflation. And while you won't make an 8-percent return, you will have the peace of mind of knowing your money will be there when you need it -- no matter what happens to the market.
Vigeland: Chris Farrell is the economics editor for Marketplace.
Survivorship Bias -- you have funds that quietly die which skew the performance results. Still, I rather passively invest in index funds like Vanguard with low expense ratios. If you can't predict performance, at least you can control costs.
I've also finally recovered from the 2007-2008 fiasco on peer to peer (p2p) lending. I am finally breaking even this year after many years of negative returns.
So, Chris, are you for or against reinstating Glass-Steagall? Or are conservative economic strategies only suitable for middle-class individuals, not for high-flying financial entrepreneurs?
And this from your December 31, 2009 interview is the kind of answer which could only survive a 30-second soundbite: "And the ones that I like essentially say there is no difference between an AIG, a Goldman Sachs, a Bank of America. They all need to be regulated the same. We need to create essentially a system where if they get into trouble, they automatically go into bankruptcy, management is wiped out, existing shareholders are wiped out and we isolate the problem that way. But we need to regulate them all the same." What happens when many of them go down at the same time and are interlinked by counterparty credit default swaps?
Finally, your Chicago business school guru Rajan's proposal to shift the counterparty risk to bondholders by crisis-borne conversion of debenture to equity, which you talk about in the 12-23-09 Business Week article, is so unpalatable that it begs for temporal and geographical exceptions that, like CDOs, soon become the rule. You never answered the replies.
