7-Step Short Cut To Calculate Realistic Investment Gains

Last update on July 7, 2013.

I knew this day would come, but not this soon.

A few days ago, I posted a comment on retirehappy.ca, seeking to start a dialog with the author. But to my surprise, I got quite an angry response from someone else - a blogger who runs lifeinsurancecanada.com (named Glenn Cooke).

Let me show you a snippet of what he wrote.

For someone who claims "Most financial advisors give unsound advice" (where’d you make up that tidbit?), you’re spewing some pretty random nonsense yourself. I guess the fact that you’re acting as a financial advisor and then post numbers like you just did kind of proves your point though.

He's flinging some pretty serious mud.

I understand why he gave this response. By saying most financial advisors are mere salesmen, I'm attacking the very foundation of how they make their living. That kind of criticism will attract angry responses the way a bear would after disturbing a hornet's nest. So in a way, I saw it coming, but I didn't know it would happen so soon.

But enough about that. Today, I want to show you a short cut for calculating realistic retirement goals. It's the  short cut I've used in my comment on retirehappy page, and it involves 7 steps.

Why I Love Short Cuts

By 'short cut', I mean a way of simplifying complex calculations by using rough math. For example, a famous one is the rule of 70, which we'll actually incorporate in our larger short cut. The rule of 70 states that if you divide 70 by the percentage returns, the result is approximately how long it takes to double your investment.

That's a mouthful, so let me explain using an example.

Let's say you expect a return of 7%/year on your investments. Then, 70/7 = 10, so it'll take approximately 10 years for your investments to double. The real result? 10.24 years, so it's very close!

I love short cuts because of 2 reasons:

First, it allows me to think on the spot. For example, let's say you're in a meeting, and someone tells you an investment has doubled in 10 years. It allows me to translate that number into percentages: in this case, 7%/year. No calculators needed - just good old division in my head.

Secondly, it allows me to double check complicated models. When you create a complicated spreadsheet of numbers, there's a good chance something's wrong in the calculation somewhere. Using short cuts allow me to anticipate what the end number should be, so that if the spreadsheet is way off, it throws me a red flag.

The 7 Steps

In my comment on retirehappy.ca, I used a short cut to calculate retirement goals. Here's how.

Step 1: First of all, let's establish that we're working in an inflation adjusted world. I'm going to assume that inflation is going to be 3%/year, which is the historic average for the past 100 years. That means that for example, $4,120 tomorrow is worth $4,000 in today's money. By working on an inflation adjusted world, we're thinking of everything in strictly "today's money".

Step 2: Assume you'll save the same amount every year, inflation adjusted. In my example, I assumed the annual savings will be $4,000/year. Again, if you don't adjust for inflation, it'll be $4,000 this year, $4,120 next year, and so forth. But in an inflation adjusted world, it'll be $4,000/year every year.

Then, multiply that number by the number of years you'll save, and that gives you how much you'll have contributed to your savings. In my example, that number came to 40 x $4,000 = $160,000.

Step 3: Assume you'll spend the same amount every year, inflation adjusted. In my example, I assumed the annual withdrawal will be $50,000/year.

Here again, multiply that number by the number of years you'll withdraw your money from. In my example, that was 20 years, so you get 20 x $50,000 = $1,000,000.

What do numbers in step 2 and 3 tell us? It tells us that you've contributed $160,000 from your income, and you'll withdraw $1,000,000 from your savings. All numbers are inflation adjusted. The difference, $840,000 of it, will have to come from investment gains.

Step 4: Calculate the average duration of investment. The 40 years of savings come before the 20 years of withdrawals. The midpoint of the 40 years of savings is year 20 (i.e. 40/2), and the midpiont of the year of withdrawal is the year 50 (i.e. 40 + 20/2). The average time that a saving is allowed to grow, is 50 - 20 = 30 years.

Step 5: Calculate the inflation adjusted rate of return on investments. I've assumed a generous 8%/year before inflation in my example. The rate of return after inflation number is 8 - 3 = 5%/year.

Step 6: Use the rule of 70 to figure out how long it would take an investment to double using the rate of return on investments. In my example it's 70/5 = 14 years.

You can use this number to figure out how much your investments will likely gain, by dividing the average investment time by the number of years it takes to double your investments. In my example, I divided 30 by 14, to get a number a little over 2. That means at 5%/year rate of return, my investments will double twice, and gain a bit more. Doubling twice gives us 4, so let's say it'll grow to 5 times the original amount.

Step 7: Multiply the sum of the savings to figure out how much your savings will grow to. In my example, I multiplied $160,000 by 5, to give $800,000.

The investment gain in this case, is $800,000 - $160,000 = $640,000. $640,000 is the 'investment gain', and it's 4 times the total amount saved ($160,000).

But wait, didn't we conclude that we'd need $840,000 in investment gains? With only $640,000, we fall far short! This is why I raised the objection in the retirehappy blog.

The Full Calculation

Whenever you use a short cut, you should ask yourself - how accurate is it? To answer this, I did a full calculation. You can view the details of my calculation in the link below.

Investment Gain Spreadsheet

I'll give you the summary. When you adjust for inflation, investment gain is about $664,000, or about 4.15 times your total savings. In addition, the couple will run out of money before they hit 85.

4.15 is pretty close to the 4 I predicted using my short cut. In other words, my short cut proved to be pretty accurate.

Now, there are ways to make this 4.15 ratio go higher. If you adjust inflation down to just 2% per year, the ratio goes up to 6.6. Or, if you assume a higher rate of return - say 9% - then the ratio goes up to 8.2.

In other words, you can paint a rosier picture than my already generous assumptions, but then you'd have to justify your rosy picture.

Of course, there are plenty of reasons why 4.15 might be an overestimate as well. If you adjust your investment rate of return down to 7% per year, the ratio goes down to under 2!

Conclusion

Perhaps my 'short cut' doesn't look much like a short cut for many of you. However, after you do it once or twice, I think you'll realize that it's quite possible to do these calculations in your head in a couple of minutes.

Finally, I'm not going to sit here and pretend that comments like Cooke's dont offend me. It does offend me. But I realize it's something I have to get used to. On the other hand, I'm very thankful that there are plenty of fee only financial advisors whom I respect, who have in turn encouraged me.

Thank you for taking the time to read, and please leave a comment if you have any questions.

 

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