43–Lever #4: Interest Earned (Part Four: Introduction to Investing)
You can't do well what you don't understand
Many people think investing is so complicated and challenging that they either 1) avoid it altogether and leave their money sitting in cash, accomplishing very little, or 2) pay someone to invest their money for them (for a fee, of course), becoming passive observers of the process.
Or, some think they are more intelligent than Wall Street and decide to take their chances by actively trading stocks in hopes of “beating the markets.” If you are a pro, then go for it (you still may not be successful; many pros aren’t; the pros do beat the markets in some years, but it’s tough to do it for many years at a time.) But if you’re not a pro—you’re not an experienced pension or hedge fund manager—you don’t want to try to manage your own investments as though you are. The pros will always beat you at their game.
In my opinion, most of these paths are suboptimal (although #2 above will be a good solution for many if they can find the right advisor, and if you are a pro, you may also be a decent stock trader–sometimes). So, in this next series of articles, I’m going to try to put you on a better path that will give you:
An understanding of the history of financial markets (it’s more interesting than it sounds);
An understanding of short-term versus long-term risks and the difference between your risk tolerance and risk capacity (this is foundational to prudent investing);
An understanding of the power of compound interest (Einstein called it the “eighth wonder of the world’);
An understanding of the power of the adverse effect of compound fees on investment returns (it’s more significant than you might think);
An understanding of an appropriate asset allocation based on your risk tolerance and your risk capacity so that you can handle occasional market corrections of 10, 20, 30, or even 40% or more (what portfolio managers get paid the big bucks for);
An understanding of what it means to diversify your investments and why it is so vital to your long-term success (a short lesson in “asset classes”);
An understanding of the wide variety of available investment options (and why you don’t need most of them);
An understanding of how to build a simple, transparent, low-cost investment portfolio that you can manage yourself with a few hours a year (maybe less!);
An understanding of the investing advisory and portfolio management services available to you, should you need one (and how to choose one that’s right for you).
Most of these things pertain to one of the most important equations that young investors need to understand: real return.
Real Return = Market Return1 – Inflation – Fees – Taxes
This seemingly simple equation explains the headwinds you face as an individual investor and how much your investments are actually growing in terms of future purchasing power, not just dollars on a screen.
Your real return is what’s left over after inflation, fees, and taxes take their bite of your investment apple. It tells you how much more your money can buy in the future (when needed) than it can today. For example, if your investments earn a 5% real return this year, that means you could afford to buy 5% more stuff next year, assuming you let your investments grow and didn’t spend the assets or earnings (an important caveat).
Imagine you could buy 100 candy bars today (I like Reese's Cups and Paydays, but I try to restrain myself). With a 5% real return, you could buy 105 candy bars next year (price increases included). Who would want to eat 105 candy bars is another matter (although that’s only one every three days or so), but that’s the power of growing your real return; it’s your future purchasing power, not just an account balance on a statement.
Breaking this down further, the market return is the return you’d get if you were to invest in every publicly traded U.S. company. This market return is the aggregate performance of the stock market, and it is almost impossible to beat by stock picking or market timing. You could invest in fewer stocks (i.e., a small slice of the market) by owning individual stocks (or bonds) or a mutual fund, in which case you’d get the market return for each security.
Want to try to beat the market instead? Good luck. Most professionals can’t do it consistently, and every time you try to outguess it, you’re competing against Wall Street computers that trade in milliseconds. Not to mention artificial intelligence (AI), which will be the next big wave in investing. Your best bet? Own the entire market or a segment of it through low-cost index funds and let them do the work. (More on index funds in future articles.)
We discussed inflation in some previous articles, but it’s very relevant to investing, as it quietly reduces the value of your money over time. That’s why $1 today may only buy $0.97 worth of stuff next year. Over time, even “low” inflation eats away at your savings. Yikes!
Historically, inflation has averaged around 2% to 3% per year. But in recent years, it's been much higher. That’s why your investments need to grow faster than inflation—otherwise, you're actually losing money in real terms.
Next are investment fees, where many young investors make costly mistakes. Let’s look at a simplified example: Suppose the market returns 6% and inflation is 3%. If you pay no fees, your real return is: 6% − 3% = 3%.
Add typical investment management fees: 1% to a financial advisor and 1% to an actively managed mutual fund. Now your real return drops to: 6% – 3% – 2% = 2%. You just lost two-thirds of your real return. That’s a massive hit, especially compounded over decades. I think you see the problem. (We’ll discuss fees further in a future article.)
We’ve also discussed taxes. The simple fact is that every time you receive an interest or dividend payment, it is (theoretically) taxable. That’s the income tax. If you sell an investment for more than you paid, you may owe taxes on the gain. These are called capital gains taxes. Let’s say you buy a stock for $100 and sell it later for $150. Your gain is $50, and it’s taxable. Capital gains rates range from 0% to 20%, depending on your income. For most young investors, the rate will be around 15%. That may not seem huge, but it adds up.
But here’s the good news: As we learned early on, you can leverage the tax code to defer or avoid many of these taxes by using tax-advantaged accounts:
Tax-deferred: Traditional 401(k), 403(b), IRA
Tax-free: Roth IRA, Roth 401(k)
Health Savings Accounts (HSA)
Certain Insurance Products (Deferred Annuities, Permanent Life)
When you understand this formula in the context of the financial life equation (FLE), you know how wealth is built. Also important is seeing how it can be lost through poor choices. You may not be able to control the market or inflation, but you can absolutely control fees and taxes within limits.
Here again is our FLE:
Wt+n = Wt + ∑It+n –∑Tt+n–∑Gt+n–∑Et+n+ ∑IEt+n–∑IPt+n
In the Financial Life Equation (FLE), investment growth is captured by the cumulative interest earned term, written as + ∑IEt+n. Along with starting wealth (W) and income (I), it’s one of the few components that add to your financial position over time. But what exactly is “interest earned”?
Although I use the term “interest earned” (IE) in the FLE, it's actually shorthand for the net investment return—the sum of all capital gains, dividends, and interest earned from investments, after subtracting any fees and taxes (if held in a taxable account). (We already account for taxes in the FLE, but I am including them here for illustrative purposes.) In formula terms:
∑IEt+1 = Market Return (Growth + Dividends + Interest) – Fees – Taxes
However, if we want to think of the FLE in terms of real financial outcomes over a lifetime, we must also adjust these returns for inflation. This provides us with the real return, which reflects the actual purchasing power of the investment gains, rather than just their nominal dollar value. So a more complete version of “interest earned” in the FLE looks like this:
∑IEt+1 = Market Return – Inflation – Fees – Taxes
This inflation-adjusted investment return is what truly matters when evaluating your ability to meet future needs, because it tells you how much more you can afford to spend in real terms, not just how big your account balance appears on paper.
The purpose of this series is straightforward: I want you to be able to approach investing with confidence, humility, and a solid biblical foundation, so that you will be up to the challenge of being your own Chief Financial Officer (CFO) / Chief Investment Officer (CIO). This is the only way for you to have some financial success in our grand IRA/401(k) experiment, as pensions have gone the way of the dinosaurs. IF YOU DON’T DO THIS, NO ONE IS GOING TO DO IT FOR YOU!
I have mentioned several times that, based on my experience, the vast majority of young adults leaving high school and college have little to no training on these topics. And even if they did, uptake is pretty low. But trust me, none of this is rocket science; you can learn it, do it, and be prepared to tackle these responsibilities in the real world with reasonable success.
Whether you know it or not, we are all, knowingly or unknowingly, walking through life as pension fund managers. While you can hire someone to do that for you, you must provide them with the assets to manage at a minimum. And you need to be able to have intelligent conversations with them. Therefore, I want to educate you before it’s too late; before you realize that you’ve missed the boat and must play catch up because the gravy train of magical compound interest left the station 20 years ago.
In my years as a financial counselor and coach, I have worked with many individuals who reached their 40s, 50s, and 60s and came to this realization. Sometimes it’s too late, and there’s only so much they can do. Other times, they have to diligently try to “catch up,” which is what my book Redeeming Retirement is all about. So, it’s best to start sooner rather than later, but that doesn’t mean you have to go “all-in” with every dollar you can spare as quickly as you can; you need to pay off debt and have something to give too. When you’re still very young, it’s not so much how much you save but to start saving something and then increase it as your income goes up (and increase your giving as well).
For reflection: Perhaps you’ve heard the saying, “The best time to plant a tree is decades ago, but the second-best time is to plant a tree today.” Similarly, the best time to put your financial house in order using biblical stewardship principles and start saving and investing is early in life. But the second-best time to do so is today. What’s stopping you? No savings? Get that emergency fund in place. Too much debt? Pay it off. No money to save? Work on those expenses. Have no idea where to start? Read the upcoming articles–I’ll tell you how.
Verse: “The sluggard does not plow in the autumn; he will seek at harvest and have nothing” (Proverbs 20:4, ESV).
In this context, market return refers to the total gain or loss on an investment over a specified period, typically expressed as a percentage of the original investment. It includes both capital appreciation (the increase or decrease in the market value of the asset) and income from the investment, such as dividends (from stocks) or interest (from bonds or savings).