Small Choices, Big Difference: Part I

This is part one in a three part series. Here is part two and part three.

As I’ve mentioned a number of times before, there is an oft cited example regarding this daily latte. Often the anecdote revolves around choosing to not purchase a coffee, and instead investing those four dollars, and over time, you’ll become a millionaire. Wow, that would be great. Here’s the problem with that math.

First, it revolves around compound interest, which is a good thing. Compound interest is essentially where the money you earn on your money, interest, is added to the principle, and you earn interest on the interest. So while it is a small amount at first, it grows and grows and grows. This part of the equation is pretty much bang on. The problem is the length of time it takes to get to the million dollar mark. In order for a $3 or $3.50 daily latte to grow to a million dollars, the stats I’ve seen have ranged from 35 to 45+ years. If we are assuming that these people are saving for retirement, that means that they will have to start saving between their 20th and 30th birthday.

Well, that’s not so bad, now is it? A lot of us fall neatly in between those two ages, so can’t we stop buying our lattes and become millionaires? Well, maybe. The other, and most important part of the equation, is the compound interest rate. Every single statistic that I’ve looked at regarding this “Latte Factor” bases the compound interest rate at a minimum of 10%. They base this off the “long term stock market return rate”. So while some years the stock market grows 12 or 15 percent, some years (aka 2008/2009) it falls, averaging out to around 10%.

I see two problems here. One, the stock market is unpredictable. The 10% figure requires that you invested at the right time, with the right amount of money, over the long term, and didn’t make any huge mistakes along the way. Two, this million dollar final figure requires that you leave your money in the stock market until the day that you choose to cash it in to retire. A lot of people have done this, and thought that they were going to retire in 2008, or 2009, or even 2010. They won’t be anymore, because while the stock market can provide the best return on your investment, it also means that it can lose a lot of your investment, preventing or delaying your retirement. If you were smart, five or ten years before you retire you would have taken your money out of the stock market, making a safer, but less lucrative investment. In that type of situation, you would be lucky to earn around 5%, and currently, it’s more like 2 or 3 percent.

Depressed? Me too. So we should give up, and spend as much money as we can while we’ve got it, yes? Well, probably not. While we might not become millionaires solely from abstaining from lattes, there are things we can do to start saving for our future – and its worth it.