In Part 1, we assert the smart way to grow wealth is through the miracle of compounding and the longer the better. The caveat is that it does require patience, but it actually works.
The miracle of compounding is one of the most successful methods of increasing wealth and is used by the best investors in the world. However, there are four key considerations to doing this:
- You must pay yourself first to get into position to save and invest.
- Realize the younger you are the more wealth potential you have; time is a great resource.
- Think of every dollar as an investment opportunity.
- The rule of 72 is a quick way to measure the future cost of today’s decisions.
Fast Forward Twenty Years
Here it is, twenty years later, and you receive the invitation to your thirtieth high school reunion a few months away. You decide to go to the reunion genuinely interested and curious to see your classmates again.
The world looks different to you now and you think about some things differently. Thinking back to past reunions you recall some of the doubts you had over the years, but they are now gone. You are glad you set some goals and developed strong habits that lasted for a long time. More things worked out right than wrong.
The Thirty Year Class Reunion
Upon arrival, you’re relieved. Almost everyone else has put on a little weight too. You’re all middle-aged and everyone seems warmer and more genuine-perhaps they look at the world differently, too. Even the ones you hardly knew seemed excited to renew the camaraderie
You find yourself in a conversation with the stockbroker and realtor. Again, they both seem to be doing well for themselves, but a little more subdued.
The conversation turns to retirement. You mention you are thinking about retiring early, maybe at age 60 but aren’t quite sure yet. There is no reaction, just an awkward silence as a fourth person approaches your group.
Everyone seems to enjoy the evening and as you are getting ready to leave both the stockbroker and realtor suggests you get together soon to reminisce some more.
You become close friends over the next year and see more of each other.
They are curious about your early retirement plans and how you are going to do that. You agree to share with each other your ideas on investing and personal financial planning.
Open and Honest Discussion
The stockbroker shares that he has been a pretty active trader and talks about some of his best trades. He also admits he’s learned some tough lessons along the way and shares some of them. He’s had some bad investments too, from trying to time the market, stock options, and day trading.
The realtor had similar experiences, some winners and some losers, with investing. But, confesses she is more concerned with paying off the mortgage. And, now thinking of getting rid of the expensive car leases. Both need to be done so they can start saving more for retirement.
They are surprised to find you save and invest in a much different way. Your simpler approach came about when you realized early on that it is hard to beat the market and “resigned” yourself to accept average market returns at best.
So, you contributed routinely to low-cost stock index funds and let the miracle of compounding work over the years.
The Future You and the Miracle of Compounding
You agree to get together for an afternoon and compare notes. You all earned about the median income of $60,000 over the years and saved 10% or $500 per month of your salary. During the time the stock market’s return was the long term average of eight percent. But, there was a huge difference in the outcomes.
How could that happen?
The Stockbroker
The stockbroker started saving and investing at age 25, like you. However, he really wasn’t able to beat the market after all.
Sure he had some great investments, the ones you heard about years ago, but there were losses that were never discussed. No one wants to talk about those.
The harsh lessons he learned over the past thirty years were chasing winners, timing the market, day trading, etc. Those strategies reduced his investment returns 6% below the market average, this is the typical result for the average individual investor as discussed here, netting him about a 2% annual return.
The 2% is well below the average long term market return and is what most active individual investors realize. His return is really not much better than a savings account and it took a lot more work.
After thirty years of investing, and at age 55, he has accumulated about $237,000 shown in the table below.
At this rate, he’ll have about $349,000 in ten years at age 65.
The Realtor
The realtor brings out her numbers. Remember that upscale house, neighborhood, and cars? Well, they are expensive, as are the furnishings, maintenance, and utilities.
And the house is still not paid for because they used a variable rate mortgage to keep payments low. It needed to be refinanced on occasion. So, they just extended the mortgage term as far as they could to keep payments lower.
She did not start saving until age 35 but hired an advisor who although led to the average market long term 8% annual return.
After 20 years of saving and investing, and at age 55, she has accumulated about $275,000 shown in the table below.
She’s still working to pay the home mortgage due to the refinancing and equity withdrawals for living expenses but if things keep going as they are she should have about $680,000 accumulated at age sixty-five.
It’s Your Turn
Now it’s your turn. You pull out your summary and explain, like the broker, you started early, at age 25. But without familiarity with investing, your approach was just to try to get an average return.
Someone convinced you to invest in the broad market, low cost, index funds since you would be satisfied with average market long term 8% annual return. So you did.
You show your friends you started at age 25 and investing in a 401-K for 30 years and will accumulate a little over $1 million ($1,034,000) by age 60 as shown below. And, it will grow to $1.5 million if you wait another five years to retire.
Your employer’s 401-K also matches your contributions dollar for dollar on the first 5% you contribute. So, your effective savings rate was actually $9,000 per year. The benefit of taking advantage of the “free money” matching contributions many employers offer means you could retire early if you wish and will have $2.3 million at age sixty-five.
Your friends congratulate you on the success of a simple and well thought through saving and index investing plan. They realize you are the millionaire next door that they read about and are well positioned to retire if you choose to do so.
You don’t mention that your significant other has done about the same in their account, and your house is mortgage free.
Everyone agrees to continue meeting periodically and share ideas. Your friends compliment your wisdom and wish they had these conversations with you 30 years ago.
You wonder-would it have done any good? Were they really willing to give up expensive cars or upscale houses for the comfortable but “ordinary life” you choose to live? Who knows?
And you, too, wish you had the chance to try to talk about the future with them.
And maybe you still can! Share these posts with a friend. It just might click, and they may be very grateful someday.
Starting Sooner is Essential
The younger you are, the wealthier you are if you save and invest to put the miracle of compounding to work early. Look at the table that summarizes a 25-year-old investor’s $500 per month savings compared to the amount that grows through compounding over each decade.
It starts slow off, and this is where some can get discouraged. But, even after ten years $60,000 is contributed and another $26,919 is gained through compounded returns. It gets better, for instance, after 20 years, there is more than a dollar of return for every dollar saved on average ($154,572/$120,000 = 1.29).
And it just gets better. After 30 years compounding produces $2.78 for every $1 you save. And, if you continue after 40 years; every $1 you contribute earns $5.48 ($1,314,339 / $240,000 = 5.475).
Making Up is Hard to Do
If you start investing later, say at age 40 instead of age 25, that 15-year delay requires you to up your savings to $13,500 per year from $6,000 per year to get to $1 million and that won’t be until age 70, instead of at age 60 as the 25-year-old starter did.
As hard or as inconvenient as it might be when you’re starting out, it can be done if you put your mind to it. The opportunity cost of a delay may cost you and your family dearly later in life.
And There is a Lot of Making Up to Do Out There
According to the Bureau of Labor Statistics, the average adult age 65 and older spend almost $49,500 a year.
And the above examples are not rare or a scare tactic. GOBankingRates surveyed adults across the U.S. in 2018 and found that 42% have less than $10,000 saved for retirement and 14% of the respondents saved nothing for retirement.
The table below summarizes the results of the survey.
If you are not sure you will be prepared for retirement put the miracle of compounding to work for you. One of the best motivators is to determine how much you might need discussed that here.
Want to calculate your own retirement? Use any one of the many free retirement calculators online here or at companies like Fidelity or Vanguard.
One response I’m sure many people will come up with is the need to get serious about savings and investment today.
What We Learned Today
- Things are not always as they appear. Trying to keep up with the Jones could mean you will work through retirement with the Jones.
- The arithmetic shows it’s simple, but it’s not easy. You need to discipline yourself to find the money to save and invest early.
- Follow these guidelines to put the miracle of compounding to work for you:
- Pay yourself first to get into position to save and invest.
- Time is your greatest resource, use your precious time to create more wealth through compounding.
- Every dollar is an investment opportunity-keep this one thought in mind.
- The rule of 72 is a quick way to measure the future cost of today’s decisions.
Good luck, you are on your way to becoming the millionaire next door.
Part 1: The Miracle of Compounding