Sunday Vibes

MONEY THOUGHTS: Rule of 72

IF you're old enough to remember the previous BIG CRISIS, you also know that cash yields have been low since 2008. Why does that matter?

After the Global Financial Crisis (GFC) of 2007-2009, Earth's cost of money became trapped at basement level interest rates. Thankfully, when economic conditions started to improve in late 2009 those rates set by various central banks rose… but not by much.

Then in early 2020 when the world again "went to hell in a hand basket", this time because of Covid-19, interest rates plummeted even more, in some cases below zero into negative territory.

Long story short, we're entombed in a low interest rate environment. (Note: Most of us consider the interest rate we receive on cash deposits in our bank fixed deposits (FD) as our de facto risk-free rate.)

In Malaysia, our FD rates are linked to Bank Negara Malaysia's (BNM's) overnight policy rate (OPR). Last year BNM cut our previous 3three per cent OPR four times by an aggregate 125 basis points.

(One basis point is one per cent of one per cent, so a shift from, say, 2.50 per cent to 2.25 per cent represents a 25-basis point cut.) Malaysia's OPR now stands at 1.75 per cent.

Every country has a different cash rate or risk-free rate. The expected long-term compounding yields of other savings and investment vehicles have to be higher than the risk-free rate, which means they have different risk premiums above the risk-free rate.

In general, equities should yield higher returns than investment in real estate, which in turn yields more than, say, bonds. Obviously, non-zero-risk bonds should grant higher long-term returns than cash.

Note: Since interest rates have fallen, IF the different risk premium differentials stay about the same, then overall returns of all asset classes must also come down.

INVESTMENT RISKS

Consider these hypothetical respective annual returns of cash, bonds, real estate investment trusts (REITs) and equities (stocks) in 2007 or earlier: four per cent, five per cent, seven per cent and 10 per cent.

The numbers are made up but they do help illustrate bond's imagined 1one percentage point risk premium over cash, and similarly REITs' three and stocks' six percentage points risk premiums over the cash rate.

So, if current cash returns are about two per cent, then if the risk premium differentials hold at their same indicative levels, we would expect bonds to now yield three per cent, REITs four per cent and stocks eight per cent.

If our diversified portfolios of yesteryear yielded relatively stable long run total gains of, say, 7.2 per cent, today we may perhaps only hope to generate six per cent by accepting more investment risk than we stomached in the past.

So, we either have to save and invest more today to meet our retirement goals for tomorrow, or accept that our hopes for future golden years must be downgraded to silver or bronze.

RULE OF 72

The Rule of 72 is a nifty mathematical trick to calculate how long it takes to double our seed capital based on a specific interest rate. Doubling our money, say RM1,000 to RM2,000, takes time. If you once had a portfolio that grew at 12 per cent a year, it took (about) six years to double in size. (Note: 72 divided by 12 = 6.)

But if your portfolio "only" grows at nine or six or four per cent, then it will take eight, 12 or 18 years to double. The "magic" number 72 makes it easy to run those usually difficult compound interest calculations in your head. (Note: 72/9 = 8; 72/6 = 12; and 72/4 = 18.)

When we consider portfolio returns, we recognise that total returns = yield plus capital gains. So, when we're still working and do not need to consume the precious passive income yield our portfolio spins out, we can permit that yield to remain in our portfolio as reinvested capital. But later, when we're retired and must extract passive income to live on, our portfolio will grow at a slower pace.

Consider this: If a risk-heavy diversified portfolio grows by six per cent a year during our working years, it will double in size every 72/6 = 12 years.

Later, in retirement, we'll assume 4four per cent of internal yield from our golden nest egg is extracted each year for living expenses. That leaves two percentage points of capital gains to fuel the portfolio's subsequent expansion (to partially compensate for snowballing inflation that erodes the purchasing power of retirees' funds).

With a mere two per cent residual growth rate, it would take an interminable 36 years to further double the portfolio once retirement starts. Now, what might you do with this information?

1. Use your understanding of the Rule of 72 to work out how long your savings and investments will take to double;

2. Do all you can to save and invest more today because we're trapped in a low interest rate environment; and

3. Arrange your affairs and align your career with your passions. If you love your work, you'll want to work longer, retire later, and thus have a shorter retirement to fund in our presently challenging low interest rate environment.

© 2021 Rajen Devadason

Rajen Devadason, CFP, is a Licensed Financial Planner, professional speaker and author. Read his free articles at www.FreeCoolArticles.com; he may be connected with on LinkedIn at www.linkedin.com/in/rajendevadason, or via rajen@RajenDevadason.com. You may also follow him on Twitter @Rajen Devadason and on Clubhouse (Rajen Devadason).

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