If you’re following along with us, we’ve discussed getting a solid financial foundation in place to start growing your wealth. The smart way to do this is through the miracle of compounding over time.
It does require patience, but it actually works over the long term. And, it’s one of the most popular methods used by the best investors in the world.
Let’s look at how to make the miracle of compounding work for the “future you,” regardless of your current financial status.
We’ll use Net Worth as the scorecard to objectively measure what progress you can expect.
The Miracle of Compounding
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Pay Yourself First
Saving and investing is a form of deferred gratification where the investor provides money now with the expectation of receiving more in the future.
Whether saving for a rainy day, retirement, or something else, it makes sense to let your money work for you. And, “pay yourself first” is one of the oldest tenets in personal finance going back centuries.
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Time is Your Greatest Resource
The youngest investors have the longest time to benefit from the miracle of compounding. That benefit accrues night and day, even if you’re only able to save a small amount.
Arnold Bennett writes that time is worth a great deal more than money anyway because “…if you have time you can obtain money..usually” but if you have money “you cannot buy yourself a minute more time than I have.”
The graph below shows the growth of $500 per month savings to age 65 if you start at Age 25, 30, 35 and 40. It assumes the average 8% long range stock market return. Starting at age 25 you will accumulate about $1.5 million compared to about $0.4 million if you wait until age 40.
So it still seems the younger you are, the wealthier you are as long as you are taking advantage of the miracle of compounding.
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Every Dollar is an Investment Opportunity
After you cover your necessary living expenses, you have the choice to either spend or save what’s left. A useful guide through those choices is the thought that every dollar is an investment opportunity.
Again deferred gratification comes to mind. It’s an essential principle behind capital accumulation and encourages individuals to postpone immediate consumption to gain more at a future date.
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The Helpful Rule of 72
You probably always wanted to do compound interest or return problems in your head. Well, maybe not, but it’s a handy tool to use and judge the merit of every dollar as an investment opportunity.
The Rule of 72 is a quick and convenient estimate of how long an investment will take to double at some return or interest rate.
For example, if you want to know how long it’ll take to double your money at the average long term stock market’s 8% return, the formula is:
Length of Time to Double in Years = 72/rate of return
When you divide eight into 72, you get nine years (72/8 = 9). So, at an average return of 8%, you’ll double your money every nine years. And for 10% you’ll double your money every seven years (72/10 = 7).
Let’s take it one step further and assume you will be saving for 30 or 40 years. How much will a dollar increase over that time? In thirty years, it will double 3.3 times (30/9 = 3.33), and in forty years it will double 4.4 times (40/9 = 4.44)
Here’s how the miracle of compounding works with an 8% return:
| 30 Year Period | 40 Year Period | ||
|---|---|---|---|
| Years | Balance | Years | Balance |
| Today | $100 | Today | $100 |
| 9 | $200 | 9 | $200 |
| 18 | $400 | 18 | $400 |
| 27 | $800 | 27 | $800 |
| 30 | $1,006 | 36 | $1,600 |
| 36 | $1,600 | 40 | $2,171 |
| 45 | $3,200 | ||
These are estimates, and we just round the numbers. If you have 30 years to invest, every $100 will grow to about $1,000, or 10 times. So, a multiple of 10X is an excellent mental rule of thumb for the next couple of years.
If you have over 40 years, every $100 will grow to about $2,200 or a multiple of 22 X is good to use as a rule of thumb for a couple of years.
The Future You
You read articles about the miracle of compounding early on, checked the arithmetic yourself, and bought into the concept.
You pay yourself first, leverage your youth, think of every dollar as an Investment, and torment yourself with the Rule of 72.
And, what do you have to show for it ten years later? A typical everyday lifestyle.
Your Typical Everyday Lifestyle
So, you’re saving 10% of your gross salary and taking advantage of your employers 5% contribution to an employer-sponsored 401-K retirement plan.
You seem to be doing reasonably well compared to your peers. You’re working to make a regular income, the median U.S. household income of $60,000 per year. It covers your needs and some luxuries.
You’re saving to buy a house and your significant other works, too. No children yet, but you’re planning on starting a family someday.
Fortunately, you signed up for automatic 401-K withdrawals from your paycheck when you were hired. Turning down the employer’s contribution was hard. It amounted to a guaranteed immediate return on your investment.
But the alternative is not a piece of cake either, because there are so many other possible uses for that money when you are starting out.
However, since you never actually receive the 401-K money because it is automatically withdrawn from your checks, you learned to live without it and are doing fine.
The Invitation
Imagine yourself coming home from work to open the mail and seeing the invitation for your ten-year high school reunion just months away. Wow, where did the years go?
You wonder how everyone is doing, so you decide to go and find out. Your classmates, of course, are wondering the same.
The Ten Year Class Reunion
At the reunion, most everyone else seems to be living pretty ordinary lives, too, with a couple of exceptions.
One is now a stockbroker and shows up in a new BMW. He indicates he’s doing very well, talking about his wealthy clients and some wildly successful trades. He is polite as always and gives you a business card in case you ever need financial advice.
The class president and a most likely to succeed candidate has become a successful realtor. She seems well on the way with an expensive new car and house in an upscale neighborhood.
After a few hours of fun and a nostalgic visit back to that critical part of your life, it’s time to go. Even more, everyone seemed to enjoy themselves and promises each other to return in the future.
You’re feeling good about what you’re doing and recall the sensible and straightforward money rules you live by. Still, some at the reunion seem to be doing much better.
Over a Cup of Coffee
The next morning, you meet a close friend for a coffee and naturally talk about the reunion. The highlights are the stockbroker and realtor’s nice lifestyle.
Your friend doesn’t really understand why you don’t just spend more to have what they have.
So, you try to explain why you think of the five dollars spent on coffee today as an investment opportunity. The alternative is to invest the five dollars in the stock market, earning the long term 8% average return per year.
You point out each dollar will double in value every nine years as a result of an 8% average return per year. So in nine years, that cup of coffee has an opportunity cost of ten dollars when missed investment returns are included.
You point out that the $5 you spent as a senior in high school would now be about $10 (doubles every 9 years at 8% growth) through the miracle of compounding.
It doesn’t stop there though, it continues through the magic of compounding. At the end of your working career of say 40 years, that cup of coffee actually cost you about $110 ($5 X 22 = $110).
Think of your next cup of coffee as an investment opportunity. Ask yourself: should I enjoy it today, or would I rather have $50 in 30 years or $110 in 40 years? Of course, you may still decide to enjoy the cup of coffee, but it is an informed choice. Curse the rule of 72!
You explain how you can change your life and maybe your future with that one thought; every dollar is an opportunity to invest.
Do you make your money work for you or spend it, not invest and, then work for more of your money?
Your friend understands but explains how they just choose to enjoy life more now.
It’s just a simple choice you both make. Time to go. You agree to meet next week, same time same place.
But still, on the way home, you start to wonder if you are thinking about this whole thing the right way.
After 5 years of saving and investing, your savings have grown to $35,200 and has the employer contribution about $52,800. You know the arithmetic and stick with what you believe (and hope) will work.
What We Learned Today
- The smart way to grow your wealth is through the miracle of compounding over time.
- This simple method is used by the best investors in the world.
- Pay yourself first to invest now and receive more money in the future.
- Time is your greatest resource. With time you can obtain money, but you cannot buy yourself more time.
- Every dollar is an investment opportunity to decide between immediate consumption or more at a future date.
- Use the helpful rule of 72 for a quick estimate of the opportunity cost of today’s purchases.
In the next article, Part 2, we’ll fast forward to the 30-year reunion to see how the power of compounding plays out.
Debt Part 3 – Five Steps out of Debt