Visit my GitHub page (link) to learn more about the python code that made this article possible.
Isn't exponential growth a mind-blowing concept? I remember first learning about it and not thinking much of it. However, the more I thought about it, the more I realized how common it is around us, and how powerful it can be. It's easy to say things like: "Only 42 people have COVID in the United States, what's the big deal? "or "Sure I'll sign the mortgage, the 5% fixed interest rate is not that bad." or "I'll keep my money under my mattress, I don't want to risk it in the stock market". At first glance, these statements seem reasonable. However, when we consider their compounding nature, they take on a completely different meaning:
In March 2020 (in the US), the number of COVID cases jumped from 42 at the start of the month to 185,000 by the end (a 4400x increase!).
Even if the fixed interest rate is set at 5%, mortgages usually last for many decades. This means that 5% is compounded yearly and could end up growing to over 100% of the home's value.
If you kept your money under your mattress from 1983 to 2024, it would be worth a third of its initial value (in real terms).
While there are countless examples of exponential growth that affect us in our lives, we will be focusing on it in the context of investing in the stock market. In this article, we will explore the long-term effects of periodically investing in the stock market, as well as how inflation affects your bottom line.
Inflation
Before getting into the importance/benefits of investing in the stock market, let's explore the worst thing that was ever invented: inflation.
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Inflation is the term used to describe how the money we have today will be worth less in the future.
One of the ways we track inflation is by looking at the consumer price index (CPI), which measures the average change over time in the prices paid by consumers for a basket of goods and services. For example, if inflation was 3% last year, this means that, on average, something that used to cost $100 will now cost $103. In other words, your money is losing value... every. day.
So, how bad is it? We can plot the CPI in the United States from 1947 to 2024 to help answer that question.
This shows the CPI to be 100 in 1983, in contrast to roughly 300 in 2024. This means that $100 of typical expenses in 1983 would cost 3x that amount in 2024!
At first, this is terrifying. Thankfully, there is a way to bypass some of the negative impacts that come with inflation, and that is for investors to place their money somewhere it will appreciate in value: real estate, private lending, loansharking, or investing in the stock market.
The Stock Market
There are many ways to invest in the stock market. For the purpose of this article, we will be looking at investing in an index fund (like TSE: XSP) that mimics the Standard & Poor's 500. The S&P 500 tracks the performance of the 500 largest companies in the United States. In fact, these top 500 companies make up roughly 80% of the total U.S. equity market capitalization (source: Morning Star). Investing in an index fund that includes all the companies in the S&P 500 is common advice, even from people like Warren Buffet:
"In my view, for most people, the best thing to do is own the S&P 500 index fund. The trick is not to pick the right company. The trick is to essentially buy all the big companies through the S&P 500 and to do it consistently and to do it in a very, very low-cost way".
Now, let's look into the outcome of investing in the S&P 500 for 40 years, from 1983 to the end of 2023.
Investing for 40 Years - Increasing Monthly Investments
Let's imagine an investor (we'll call her Sabrina) who is about to embark on a lifetime of textbook S&P investing:
She has purchased $50,000 worth of shares (at the start of 1983).
She is willing to invest an additional $2,000 per month from 1983 to 2023.
She is willing to increase her monthly investment by the inflation rate. For example, if the inflation rate is 1%, then instead of investing $2,000, she'll invest $2,020.
When she receives dividends (once per year), she will automatically reinvest them into the index.
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A dividend is a small payment made by a company to its shareholders. In the context of typical indices that track the S&P 500, the yearly dividend was between 1% and 4% from 1985 to 2024.
It's as simple as it gets as far as investing goes. It will be interesting to take a look at two main metrics: her nominal net worth, and her real net worth.
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Nominal money is the amount of money measured in current dollars without adjusting for inflation, whereas real money accounts for inflation by measuring how valuable your money is in today's terms.
Essentially, the most important number to consider is the real net worth. When planning for the future, we need to understand how much our money will be worth in the future. Therefore, it's crucial to account for inflation and focus on the real net worth. Nonetheless, we can plot both Sabrina's real and nominal net worth after 40 years of investing in the S&P 500.
In the lighter blue, we can see that Sabrina will have a net worth of $17,100,000, which is equivalent to enjoying a 10% year-over-year (YoY) return. However, as explained previously, life (on Earth) is a lot more expensive in the future, and inflation was able to grow at an exponential rate. Once we take into account inflation, we get the darker blue curve, which illustrates that Sabrina has $8,200,000 of "real" money (equivalent to a little less than 7% YoY return).
There are a couple interesting things to note here:
The gap between the light blue (nominal) and the dark blue (true) lines seems to get wider and wider as time goes on, even though she is increasing her monthly investments to follow the inflation rate. This showcases the magnitude of the inflation rate, which cuts Sabrina's spending power in half. More on this below.
This method of investing is similar to enjoying a 7% YoY return. When people say that investing in the S&P yields roughly 10% per year, this is only true at the nominal level, and therefore doesn't mean much.
For those who prefer tables, we can see the growth in both nominal and real terms, as well as the percentage difference between the two.
| Year | Nominal Net Worth | Real Net Worth | Percentage Difference |
| Year 0 | $50,000 | $50,000 | 0% |
| Year 10 | $680,000 | $538,000 | -21% |
| Year 20 | $2,630,000 | $1,780,000 | -32% |
| Year 30 | $6,350,000 | $3,830,000 | -40% |
| Year 39 | $17,120,000 | $8,180,000 | -52% |
As explained by the first bullet point above, inflation does not seem to matter much in the first 10 years. The difference between nominal and real net worth is only about 21% (or $142,000). However, once we allow a lot more time to pass (39 years), we see that inflation has wiped out almost half of Sabrina's spending power (which amounts to more than $8,000,000!). Even though the average inflation rate was around 3.5% in the United States from 1985 to 2024, it was solely responsible for a 50% decrease in Sabrina's spending power...
Investing for 40 Years - Stagnant Monthly Investments and No Dividends
Let's imagine two other investors (we'll call them Mark and Donald), who are going to follow the same investing rules as Sabrina, except for two things:
Mark is not willing to increase his monthly investment by the inflation rate. He will always invest $2,000 per month for the next 40 years.
Donald is not willing to reinvest his yearly dividends and decides to spend them on luxury goods instead.
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Side note: I called Mark "Mark" because he doesn't increase his Monthly investments, and Donald "Donald" because he spends his yearly Dividends.
To summarize the differences between Sabrina, Mark, and Donald, we can refer to this table:
| Sabrina | Mark | Donald |
| Starting Investment | $50,000 | $50,000 | $50,000 |
| Monthly Investment | $2,000 | $2,000 | $2,000 |
| Reinvesting Dividends | Yes | Yes | No |
| Increase Monthly Investments | Yes | No | Yes |
What will be the impact of Sabrina and Donald increasing their investments to keep up with inflation compared to Mark, who did not? What about the impact of Donald consistently taking out his dividends to spend on other things? We can look at the next graph.
As we already know, Sabrina ends up with roughly $8,200,000 of real net worth. This is compared to Mark's $5,900,000 and Donald's $5,100,000. If the primary goal is to save the most money for retirement, the moral of the story is quite clear:
For the periods between 1985 and 2024, investors who increased their investments by the going inflation rate had a large advantage compared to those who did not. In the short term, this meant increasing the yearly amount by only 3% (ish), which is equivalent to $60 (if we're investing $2,000 per month). Those seemingly minor incremental increases (like the $60) was equivalent to over $2,000,000 in the long run.
For the periods between 1985 and 2024, even though dividends were between 1% and 4%, reinvesting instead of spending them would have a monstrous impact, increasing total net worth by 61%!
Conclusion
Exponential growth is a powerful concept that should significantly impact our financial decisions, especially when it comes to investing and dealing with inflation. By understanding how inflation eats away at your cumulative wealth over time, we can make more informed choices about where to place our savings.
Investing in the stock market, especially in index funds like the S&P 500, can help reduce the negative effects of inflation and grow our wealth over time. As shown above, two key strategies to combat inflation are (1) consistently increasing investments to match inflation and (2) reinvesting dividends. By following these practices, and assuming similar market behaviour in the future, investors can expect upwards of 60% more retirement savings after 35+ years compared to not using these strategies.
Visit my GitHub page (link) to learn more about the python code that made this article possible.
Disclaimer: The information provided in this article is for general informational purposes only and is based on historical data of the S&P 500 from 1983 to 2024. Past performance is not indicative of future results, and the financial markets are subject to various risks and uncertainties. This article does not constitute financial advice and should not be taken as such. Readers are encouraged to conduct their own research and consult with a qualified financial advisor before making any investment decisions. The author and publisher of this article are not responsible for any financial losses or damages incurred from following the information presented herein.
