How Money Really Works, Part 5: Why Some Money Grows Faster

7. The safe return

Why some money grows faster, in seven parts, and what pays for every extra percent of growth. Number seven: you start from the safe return, the rate every other return is measured from. The IMF says that when interest rates are high and inflation is low, savers can earn returns simply by parking their funds. Those funds sit in short government bills or similar safe assets, and the bill pays its interest.

The IMF says this safe asset return influences the return on other investments. That includes long-term government bonds, bank deposits, and company bonds and shares. Each of them pays its own rate, measured from the safe one. The IMF says returns on these riskier assets tend to rise and fall in line with the safe asset return.

So a bond certificate that pays more than a short government bill is paying above the safe line. Every return above the safe one is extra growth for your money. The next six items explain what pays for that extra growth. The IMF says the ability to take risks and the appetite for doing so vary.

Households, firms and financial institutions all act differently, the IMF adds. The safe return itself changes over time, because a government bill follows interest rates. Rates and rules differ where you live, so the safe line sits at a different height in different places. Every rate above that safe line has a reason, and number six puts a number on it.

Subscribe for the next parts of this series: every number here comes from the IMF and the World Bank, linked below.

6. The extra rate for risk

For number six, you take the rate on a loan and subtract the safe rate, and what is left is the pay for risk. The World Bank defines the risk premium on lending as the interest rate banks charge private sector customers on loans. From that rate it subtracts the risk free treasury bill rate, at which short-term government securities are issued or traded. In part four, the bank's spread was measured from the deposit rate; this gap is measured from the safe bill rate.

A loan contract shows the rate the bank charges, and a treasury bill shows the safe rate beneath it. By our count of World Bank data, the median risk premium on lending in twenty twenty-four was about four percentage points. In some places this spread may be negative, the World Bank notes. There, the market sees its best corporate clients as lower risk than the government.

The lender who carries more risk earns that extra rate. That extra rate is one reason some money grows faster than money kept in the safest place. The IMF says savers may turn to riskier assets in the hope of higher returns. That extra is a hope that comes with the risk, and it is never a promise.

The World Bank notes that the terms and conditions attached to lending rates differ from place to place. Those different loan terms limit how well one lending rate compares with another. Rates and rules differ where you live, so the gap on your own loan contract can look different. Governments borrow too, and number five shows the same pay for risk in their bonds.

5. Why some bonds pay more

Number five: you set two government bonds of the same length side by side, and the higher yield marks the borrower with more risk. The IMF says the bonds of major advanced economies are generally considered safe. The IMF says investors generally expect those governments to repay the bonds. The IMF says a government less certain to pay back carries a country risk premium.

So its bond yields are generally higher across all maturities. The extra yield shows up at every length of bond, short or long, not only on the long ones. The IMF calls this difference in bond yields the spread. It says the spread is an important indicator of a government's credit risk.

The buyer of the higher-yield bond is paid more because repayment is less certain. That extra yield is the pay for risk, just like the loan premium in number six. For the bond buyer, a wider spread means each bond certificate pays a bigger yield. Over the years, that bigger yield is what lets the money grow faster.

The spread moves as investors judge the risk, so the extra yield does not stay fixed. Rules and taxes on bonds differ where you live, so the yield you keep can differ too. Shares carry a different kind of risk, and number four shows what it looks like. In one breath: a safe rate to start from, about four points more for risk on loans, and higher yields on less certain bonds.

The last four show how that risk turns into growth: swings, spreading, time and compounding.

4. Swings, the price of growth

At number four, you look at how far a share price moves in a year, not only where it ends. By our count of World Bank data for twenty fifteen to twenty twenty-one, the weakest median return came right before the strongest. That weakest year was twenty twenty, and the strongest was twenty twenty-one. The World Bank measures stock price volatility as the average of the 360 day volatility of a market's whole index.

That figure shows how far the share prices of a whole market move around over a year. By our count of World Bank data, the median market's price volatility was about 12% in twenty eighteen. By the same count, it was about 19% in twenty twenty-one. The World Bank measures stock market return as the growth rate of a market's annual average index.

By our count of the same data, the median market return was about minus 6% in twenty twenty. In twenty twenty-one, the median market return was about plus 20%, by our count. Those swings are the risk that the extra growth of shares comes with. These figures are medians of whole markets, so they describe a market's index, not any one share.

They also cover past years, and past years do not repeat on a schedule. Rates and rules differ where you live, so each market's own record carries its own numbers. Number three shows one way to make those swings smaller.

3. Spreading your money out

Here's number three: you spread your money over many holdings, so no single one decides your year. In our count, spreading out made the worst year much smaller and kept most of the best year. An IMF article says holdings that move less in step with the broad markets help reduce risk by diversifying a portfolio. By our count of World Bank data from twenty fifteen to twenty twenty-one, the typical single market's worst year was about minus 11%.

The yearly average of those markets had a worst year of about minus 4%, by our count. Its best year was still a rise of about 21%, by our count, against about twenty-five for a typical single market. By our count, the average's worst year was less deep than most single markets' worst years. By our count, the average gives up about four points of its best year and cuts about seven from its worst.

Money spread over many holdings rides the swings of share prices more smoothly. Our count averages the markets' yearly returns: a picture of spreading, not something you can buy. Spreading makes swings smaller without removing them, and the worst year of the average is still below zero. Rates, rules and the holdings open to savers differ where you live.

Spreading works across holdings, and number two works across years. If you want the bigger picture, the video on how to become a millionaire is linked on screen. So far: a safe line, pay for risk on loans and bonds, the swings, and spreading them out.

2. Time on your side

With number two, you give the money that swings more years, holding it through the ups and downs. A share held for many years stays in the account through every rise and every dip. An IMF article says that over very long periods, holding for the long run almost always does well. The same article says the length of time and the starting point can matter enormously when buying.

A share bought at a high price and one bought lower end up with different gains. For money that stays for many years, the price swings of number four matter less. Each extra year gives the savings more time to earn, and the earnings then earn as well. Almost always is not always, and a long hold still has no fixed result.

Every holding is different, because each share has its own price on its own buying day. Rules and taxes on a holding differ where you live, and they shape what the money keeps. The years a holding stays put are what let a higher average return show its full size. Before number one, a guess: at 8% a year, how many years does money take to double?

1. A higher return, compounding

Number one: you let a higher average return compound, and by our count, at 8% a year, money doubles in about nine years. An IMF article says that over hundreds of years, stock returns have averaged about 8% a year. A gap of a few points a year turns into thousands of dollars over decades. That happens because each year's growth earns growth of its own on a bigger balance.

By our count, $1,000 at 8% a year grows to about $2,159 in ten years. At about 3.7%, the rate from part four, the same $1,000 reaches about 1,435. By our count, after thirty years, 8% turns $1,000 into about $10,063. By our count, that is a little more than three doublings in thirty years.

At about 3.7%, thirty years turn it into about $2,957, by our count. By our count, that is about 3.4 times as much, from a gap of about four points a year. In part four, money at about 3.7% doubled in a little over nineteen years; at 8%, about nine. This is why some money grows faster: the extra return for risk compounds year after year.

The same IMF article notes that share prices can stay flat for several decades. So an average return is not a promise, and a share certificate carries no fixed rate. Our counts assume the same rate every single year. Rates and taxes differ where you live, so the final balance differs too.

That's all seven, so here is why some money grows faster, in seven short lines.

Recap

Number seven: every return is measured from the safe return. Number six: the rate above it on a loan is the pay for risk. Number five: a higher bond yield marks a borrower less certain to pay back. Number four: the swings are what the extra growth of shares comes with.

Number three: spreading out makes the worst year much smaller. Number two: over very long periods, holding almost always does well. Number one: a higher average return, compounding, doubles money in about nine years. Today, you can open the World Bank's risk premium page, linked below, and find the latest number.

Which of these seven changed how you see a return? Tell us in the comments. Results vary, rules differ where you live, and this is information only, not financial advice. Next on Wealth Filings, part one: why money is a promise, from coins to your bank balance, linked on screen.