A few weeks ago, I was invited to teach an introduction to personal finance class to a group of local 8th graders. Two of the concepts we covered were compounding and why you need to have a real return (return above inflation). During the class, we reviewed charts of investment returns since 1926 and the difference in real wealth growth over time. The numbers were staggering.
We compared an initial investment of $10,000 in 1926 between a small cap index with a real return of 8.9% versus one month T bills with a real return of 0.3%. The resulting real return was $39m+ versus $13,372*. One student went home and told his mom “I need earned income to start a Roth IRA and this CD I bought isn’t cutting it!”. This kid gets it!
With short-term interest rates currently up over 5%, there is a very real temptation to stick with the safety of a 5% risk-free return. But a wise investor will instead look at their unique situation to help influence how much safety they need with the understanding they could be leaving substantial additional earnings on the table.
Behavioral scientists have found that losing money is far more painful than making money is pleasurable. For an excellent deep dive on this topic, Gabriel wrote an article called “Negativity Bias and the Financial Markets” that is worth reading. The gist is this: Our emotions are often our own worst enemy when it comes to investing. We go to great lengths to protect ourselves from the pain of our investments falling, sometimes at the expense of building true wealth. This became a very expensive lesson for those who fell into this trap in 2023.
Your goals should drive your investments, so if money is needed for near-term expenses or you have a short time horizon, taking advantage of short-term interest rates is prudent. If you have a longer time horizon or are investing for future generations, sticking to a disciplined plan that captures real returns is often the wiser choice.
As always, the examples used in this article are intended for general demonstration and are in no way meant to replace the advice of your trusted financial advisor.
* Source DFA Matrix Book 2023. Dimensional US Small Cap Index. US Consumer Price Index for Inflation. One-Month US Treasury Bills
- Putting your business cash to work - May 16, 2024
- Out of the Mouths of Babes - April 17, 2024
- It’s a new year: What we know and what is to come - January 8, 2021