One of my recent favorite blogs is The single dollar, primarily because she links to Smitten Kitchen archives, and I really love the Smitten Kitchen.
Anyhow, she recently wrote about the Parable of the Savers, and how its pretty much the dumbest thing in the personal finance world. Which she is right about. However, I would like to explain why she (and I) are right from a "rightest" perspective as opposed to a "leftist" perspective. That is to say, I may attempt to use facts and made up numbers pulled directly from my ass to convince you of my position, rather than my feelings.
The parable of the savers exists to convince you to deploy money into the S&P 500 (preferably using a low fee provider like Vanguard) at a young age, so that you will be comfortably rich at an older age. Why will you be comfortably rich? MAGICAL COMPOUND Growth!!!!!!
Compound growth isn't Magical!
This is my beef. Compound growth isn't magical, and one should be wary assuming that it is. The parable of the savers assumes this magical 8% return based off of approximately 200 years of human history, a mere drop in the bucket of time. (I have decide to link to Barenaked Ladies Big Bang Theory, because I think its funny and mildly relevant).
Now, I will explain to you how compound growth actually works, so that you can knowledgeably decide whether to invest in index funds or guns and canned food (you know, to be a prepper- that show is fascinating and available on Netflix).
How math works
The fact that 8% grows exponentially rather than linearly is practically irrelevant to the discussion (though it is true), but I feel the need to show a mathematical concept here. When something grows, it typically grows on a basis of itself rather than on the whole. This means that no matter how small of a something you start with, as long as you are growing in a positive direction (no matter how slowly), given enough time you reach infinity. Interestingly. the concept would work in the presence of geometric rather than exponential growth given certain parameters.
The stock market and broadly speaking the entire world economy has been observed to follow this trend of exponential growth rather than linear growth or shrinking. What I aim to discuss is not whether or not math works like this (see chart, it does), but rather whether or not money works this way.
A Tale of Two Economies
Underlying any discussion about compound growth of money must recognize that money and the value thereof is directly tied to the some "real" economic value produced in a "real" marketplace which shall from henceforth be called "The Real Economy."
The real economy exists when human beings freely exchange goods and services for their mutual benefit. Pretty much any society that has ever succeeded for longer than 15 minutes had at least a rudimentary market. Markets arise anywhere that goods and services are freely exchanged for other goods and services- they don't specifically require money (as you will soon find out). However, markets specifically rely on "ownership principles" which is to say that the humans engaged in the transaction have a fundamental right to exchange goods and services because they are the owner and have dominion over those goods and services being exchanged.
It should be noted that even in the last 200 years, ownership principles are observed lightly at best. Usually, we call the failure of recognizing ownership principles tragedies because these include ongoing tragic events like slavery, World War I, World War II, terrorist acts, and parts of any American conflict in the Middle East since the institution of Israel, the Khmer Rouge, Stalin and any policy in the USSR, basically any interaction between Europeans and Native Americans (who contrary to popular belief have ownership principles, they are just much to complex to share here), and the IRS (interestingly the Affordable Care Act escapes the list on a technicality).
Markets collapse when the underpinnings of ownership principles are ignored, and society usually goes to shit for a while the Markets collapse (an entire book was written on this called the Moral Case for Economic Growth, but I have a hard time recommending it due to the fact that his authority is about the same as mine, but he has a PhD after his name).
I think it's very important to understand that markets are allowed to expand or contract as the humans involved decide to trade more (expand) or trade less (contract). Theoretically, this change in market size may or may not be directly connected to the well being of the market participants or non-participants.
To Clarify, I've said nothing about money.
I just want to double check that you are listening. I've said nothing about money. This in on purpose. Carry on.
Free Markets are the most efficient human invention ever.
Now, I'm going to make a completely unsubstantiated claim, but I dare you to prove me wrong. Free markets, in connection strongly enforced ownership principles have proved to be the most efficient mechanism in human history at achieving the goal of the mechanism. (Prove me wrong, I dare you. And don't say atomic bombs because the waste since the dropping of the atomic bomb has been tremendous).
The goal of free markets is to increase the number of mutually beneficial transactions among human beings, and wherever strong ownership principles have existed, markets have grown in size and efficiency. I could probably find a fact on Google to support that, but for the sake of argument, I will say that where there has been strong ownership principles, the real economy has tended to expand at a rate of about 5% a year (pulled directly from my ass- you're welcome).
Personally, I don't think that the outflow of strong ownership and freedom to transact is necessarily a growth in the "Real Economy", but I can see a logical connection between the two. Real economists will try to convince you of the necessity of the connection, whereas I will merely point you to a fictional book by Ken Follett called Pillars of the Earth which is a great read and will convince you too (or at least you will have enjoyed yourself for several hours- again, you're welcome).
In which I finally talk about money
While the free market (supporting the "real economy") is the most efficient mechanism in human history, there is one that closely supports this which is the financial economy. This economy is also called the secondary economy, but it will henceforth be called the "fake economy" to ensure that you understand the conceptual difference between the "real economy" and the financial economy.
In order to ease the burden of transaction (I'll trade my donkey to Don for his wheat, who will trade his newly found donkey for Erick's Water, who will trade the donkey to Jack for 3 pokemon cards, and Erick will give me the pokemon cards in exchange for the wheat), humans invented money. Money and different variations thereof is the only product available in the secondary economy.
Exeter and his ilk will try to convince you that money is financially backed by gold as a store of value, but please don't be tricked. Gold is just another good available to be purchased in the "real economy" it's value is therein determined.
After the free market, I would say money is the most amazing human invention. Money enables me to buy pokemon cards directly, and it speeds transactions. Nearly everyone in the world believes in the use of money (or other fiat currencies), and it "greases the wheels of the real economy."
Money is in fact so widely accepted as a store of value and a means of exchange that people have started creating products in the "Fake Economy" to increase their ability to transact in the "Real Economy". How you interact with the "Fake Economy" is at the root of the whole personal finance world, and it largely determines your future potential of interacting with the "real economy".
Do you want to know why? Compound Interest.
To reiterate, Compound interest is not magical.
Now, I'm finally going to explain how compound interest works.
Let us assume that I want to consume something from the real economy (let's say Pokemon cards), but I have nothing of value to offer right now, but I have a promise of value to offer later. One product that Mr. MasterCard or Mr. Visa could offer to me is debt.
Essentially, by offering me a "Fake Economy" product called debt, Mr. Visa is saying to me, I will give you freely this representation of the real economy called money right now, so you can buy pokemon cards. But in exchange for my money now I want that same representation later, plus, I want an even greater representation of the real economy in the future (interest for delayed gratification for Mr. Visa), plus an even greater representation of the real economy in the future based on the risk that you might not pay me back (interest for the risk born by Mr. Visa), and I want the payment to be in the "Fake Economy", so he might tack on a bit extra for the difference of expansion between the Fake Economy and the real economy (inflation).
The greater the representation of the future real economy that will be required of me, the worse of a deal that this debt seems to me. However, any debt at all will require me to offer more to the real economy in the future, and I will get to consume less in the future.
Some personal finance bloggers will even insert a little addendum of how you can say "suck it" to your creditors, and get 0 interest loans and cashback, and all that, but I find that pretty boring, so I'll shy away from that.
Debt is the easiest part of the compound interest equation to understand because unfortunately many people have taken on personal debt and have thereby reduced their ability to consume real goods and services in the future because their creditors demand money and lots of it. Additionally, the fact that this grows on a percentage basis is easy to understand because we have interest rates. If this confuses you at all, I'm going to need you to back and review "Math"
Some people will simplistically say that investing is the opposite of debt. Wrong! Lending is not necessarily equivalent to investing.
I could lend money and continually get greater shares of the future economy provided that my debtors paid me, but that seems a bit risky to me, as I know too many people who want my money but end up in jail shortly after asking me. I'm definitely better off keeping my money.
Typically, investing has little to do with lending and much more to do with purchasing the future.
Within the secondary economy there is also another method of obtaining future shares of the real economy. This is by buying "monetized representations of future real economic transactions" or stocks (or other real stores of value such as rental real estate).
Certain entities exist seemingly for the exclusive purpose of expanding the number and size of their transactions in the real (or even in the fake) economy. We call these entities businesses. Businesses are difficult to understand because they are run by human beings, but they seem to operate with an ongoing and nearly infinite appetite for future returns (ie they continually want to produce value at a faster rate than they consume it). Their desire for transacting knows so little bounds that they are actually willing to take your money today, to expand their own ability to interact, and in exchange they give you a share of all future transactions. If you're buying a stock, you are buying a future share of all transactions. Typically, businesses are able to convert assets (money) into real value at a rate relative to the assets they own. The rate doesn't increase too much when they own more assets, but the more assets they own, the greater the total amount converted is (see math above- rates are a % of total).
If a business were a human, you might have little desire to put your "Fake economy" into this "Real Economy" investment vehicle. After all, humans get old and die, and then your fake economy investment would have no value in the real economy because it no longer represented any real value. Businesses also get old and die, but most of them don't exactly die so much as get to the point where they are unable to continue expanding their value at a rate as a % of total at which point their assets are absorbed into other businesses that can convert into value at a rate as a % of total.
A businesses that actualizes growth in the real economy will typically result in a growth in the secondary market at approximately the same rate (with major fluctuations due to inefficiencies and information inequality in both the real and the fake economies). The growth will be reflected in a growing stock price, dividends, or both, either of which can be exchanged at any time (sometimes with penalties) for money which can then be spent in the real economy (provided the service provider accepts money).
The magic isn't the math... it's the businesses
It's easy to see how math works. What is crazy is that humans will take on debt at an interest rate and that businesses will expand real economies at a rate. I can't totally understand that. I sit at my computer and flap my lips into my headset, and type code, and suddenly Major Retailer expands 6%! Amazing! And next year, it's going to happen all over again! The fact that this has gone on, more or less uninterrupted for 200 years is truly pretty nuts. Not magical, but it does defy any expectations that you might have of the world around you. Which might be why you haven't started investing.
Please, don't let that be the thing that prevents you from investing. If fear keeps you from investing, then I need you to be buying lots of guns and canned foods, and I'm serious about that. You should also live in a bunker.
What might hinder the compound growth
This is where leftists and rightists disagree. Rightists believe the system could pretty much expand to infinity and we are mainly concerned about the diminishing of fundamental ownership rights that would undermine the real economy. This explains why we like drilling for oil and deregulation and we hate taxes. Leftists are primarily concerned that the whole system is unsustainable and that businesses couldn't possibly continue to produce value forever. This explains why they dislike drilling for oil and want to spend lots of money on education.
Compound growth: It's officially not magical!
But I hope you enjoy the benefits anyhow!
I'm a wife, a mom, an employee, and a personal finance nerd who is devoted to spreadsheeting my way through life.