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  • Writer's pictureNicholas Pihl

Not-so-Dumb-Guy Stock Market Math

The concept I'm sharing here is technically wrong, but I think it actually yields a better way to think about saving and investing in the stock market.

The basic problem most of us have with investing is that our human brains don't do a good job with compound interest. 10% growth doesn't sound like much. For instance, maybe you've $1,000 and you're thinking of investing it instead of buying a new tv. You figure, "if that money grows 10% a year, it makes me $100. Is it worth not having a new tv just so I can have $100 extra a year from now?" A year feels like a long time, and so most people buy the tv.

But that's not really the right way to look at investing. To really see the benefits of compound interest, you should ask, "is it worth investing that $1,000 for the sake of getting $10,834.70 in 25 years?" The real value of compound growth is what happens in the final years of growth, not what happens in year one.

If you look at the stock market the way that people normally do, it doesn't offer much appeal. Specifically, the market drops 20-30% every 2-3 years, while averaging only 10% a year over the long term. That doesn't look like a smart bet because you're taking substantial risk for a chance at mediocre growth. The problem with this thinking is that it is inherently short term. People have a hard time thinking more than 6-18 months in advance. Anything beyond that tends to be lost on them.

Usually when people talk about compound growth they show these really impressive numbers and stop there. And your average, common sense person says, "yeah, but 25 years is a long time. Anything can happen between now and then, whereas I know for a fact that I can benefit from using that money today to enhance my life." They're not totally wrong. The problem is that making this your financial philosophy means failing to achieve any level of financial freedom, or even security.

Here's where my "wrong but useful math comes in."

If you take that $10,834.70 (a gain of $9,834.70, or roughly 10x your initial investment), and spread it evenly over those 25 years, something interesting happens. Divided into 25 even pieces, $9,834.70 becomes roughly $393 per year, on just $1000 invested. Which is not the mathematical reality in year one, nor even year 20, but it's closer to the truth from the standpoint of how much you're really making if you can stay invested for 25 years like that. It just brings it into the present moment.

When friends ask why I save so much money, it's not because I'm getting 39.3% returns on every dollar saved. It's just that I know how money grows, and I know every $1000 saved this year is effectively paying me $393 per year over the next 25 years. Maybe that's dumb, but I think it more closely represents the long term impact of financial decisions made today.

If I were to ask a crowd, "would you be willing to save $1000 if it meant earning $393 in interest per year for 25 years," I bet a lot more people would say yes. In fact, I bet that many of them would think it foolhardy not to save at least 20% of their income. It's such an amazing deal, why wouldn't you take advantage of it?

And here's the secret. This isn't a hypothetical. Everyone has access to this same deal.

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