There's a real allure to the idea of your investments turning one dollar into two. The catch is how long that takes to happen. Hucksters pitch dubious investments that can double your capital in a month, six months, or a year. In real life, sensible investments such as mutual funds can double your money periodically as well. A 10-year cycle is attainable, though it depends on several factors.
The Rule of 72
The math to calculate compound growth is complicated, but a rough equation called the "rule of 72" provides a good rule of thumb. To estimate how long an investment takes to double, divide 72 by the percentage of growth. For example, if your fund has averaged 6 percent returns, divide 72 by 6 percent and you'll find that it takes 12 years to double your money. At 10 percent, it takes just 7.2 years. For a 10-year cycle, your fund needs to average a return of approximately 7.2 percent. However, there are other factors at play.
In the real world, your investments might grow at a steady rate but the purchasing power of a dollar does not. Historically, the U.S. inflation rate averaged approximately 3 percent between 1926 and 2007. So, if a mutual fund averages 7.2 percent over 10 years and doubles your money, your purchasing power hasn't doubled with it because of inflation. Your real gain is only 4.2 per year -- your fund's 7.2 percent return minus 3 percent inflation. At that rate, it will take over 17 years for your purchasing power to double. To allow for inflation, you'll need to average a 10.2 percent return.
Taxation and Management Fees
There's still more bad news. That increase in the value of your mutual fund can represent capital gains, interest income or dividend income, all of which are taxable at different rates. That's why retirement planning focuses heavily on IRAs and 401(k)s, whose growth is sheltered from taxation. The same is true of annuities and investment-oriented insurance policies, though they have more limitations and higher costs. Costs such as management fees and commissions are another hidden factor that can erode your earning power. A 1-percent difference in management costs can sap your retirement income more than you think.
Historic Rates of Return
In the small print at the bottom of any mutual fund advertisement you've ever seen, far below the massive headlines and graphs trumpeting their gaudy returns, you'll find a most important disclaimer. It says that you're looking at their historic rate of return, and their future performance isn't guaranteed. In other words, like your favorite football team, they might not be as good in the future as they were in the past. Over the longer term, the Standard & Poor's 500 stock index has risen an average of 10.5 percent per year. Index funds, which track the S&P; and similar indices, will mirror those numbers.
Double or Nothing
It takes a relatively short time with a calculator and a scratch pad to realize that doubling the dollar amount of your investment is relatively easy. Doubling your real purchasing power is hard. Fortunately, long-term investment isn't a "double or nothing" proposition. Maximize your money's growth by paying attention to the basics. Keep as much of your money as possible in tax-sheltered vehicles. Choose mutual funds, ideally index-linked funds, for their low management fees and long-term stability. Your purchasing power might not double every 10 years, but you'll maximize the returns from your investment in funds.
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