Imagine a financial superpower that turns pennies into piles of cash. That's the magic of compound interest, which was also called the "eighth wonder of the world" by Albert Einstein. For those with time, it's like having a time machine in their pocket, accelerating wealth creation over the long term.
Many of you may have heard me say this: The secret to successful investing isn't picking the next TSLA or NVDA. The secret to successful investing is time and discipline.
Compound Interest: Money Making Money
At its core, compound interest is interest earned on both the initial principal amount you invest and the accumulated interest from previous periods. It's essentially "money making money," the longer your money has time to compound, the greater its growth potential.
Here's a simplified example:
Let's say you invest $1,000 at an annual interest rate of 7%. In the first year, you earn $70 in interest, bringing your total to $1,070. In the second year, you earn interest on not only the original $1,000 but also on the $70 you earned the previous year. So, you earn $74.90 in year two, for $1,144.90. This snowball effect continues year after year, with your earnings growing exponentially.
The Million Dollar Delay
The power of compounding becomes truly evident over longer timeframes. Consider this: if you invest $6,000 at age 20 with an average 7% annual return (compounded annually) and leave it untouched until retirement at age 67, you would have $144,274! That's a 2,304.56% return from beginning to end. You only invested $6,000 47 years before.
Now, consider our friends Mike, Tom, and Buck.
Mike makes contributions of $6,000 a year starting at age 20. He does this year after year for the next 47 years. With an average 7% annual return, by the time Mike reaches age 67, he will have $2,113,620 in his account!
Compare this to Tom. Tom spent his first ten years playing, dining, traveling, and enjoying life. He waits until age 30 to start, making annual contributions of $6,000 yearly for the next 37 years (instead of Mike's 47 years). When Tom reaches age 67, his account will have an ending balance of $1,029,366.
As you can see, missing out on saving the first ten years cost Tom $1.08 million!
Now, let's consider Buck. Buck starts saving at age 20, just like Mike. He saves $6,000 a year. But unlike Mike, Buck stops saving altogether at age 30. The $60,000 Buck saved over the first ten years continues to invest and grow at an average annual rate of 7%. By age 67, Buck's account would have grown to $1,084,254.
While it's true that Mike still has the highest balance at age 67 ($2.11 million), it's noteworthy that Buck's ending balance ($1.08 million) is still higher than Tom's ($1.03 million) at age 67. Remember that Buck only saved $60,000 over the first ten years, while Tom saved $222,000 over the last 37 years. Tom couldn't keep up with the compounding growth in Buck's account because Tom started later.
This is the power of compounding through time and discipline.
Young people have a distinct advantage in early investing. Here's why:
Time Horizon: Young adults have a longer investment horizon than those nearing retirement. This extended timeline allows market fluctuations to even out and compounding to work its magic.
Habit Formation: Starting early instills a habit of regular saving and investing, a crucial financial discipline for long-term success.
Risk Tolerance: Young people generally have a higher risk tolerance than those closer to retirement. This allows them to invest in higher-return assets, which can further accelerate growth through compounding.
Investing for the Future: Small Steps, Big Results
While the numbers might seem overwhelming, starting small is key. Even seemingly insignificant amounts can grow substantially over time. If you invest just $25 per week (roughly $1,300 per year) with an average annual return of 7% (compounded annually) from age 20 for 47 years, you would accumulate to over $450,000 by age 67.
What to Invest In?
These numbers are staggering indeed. Anybody can be a millionaire at retirement, as long as they put in the time and the discipline to save. You can save this into a taxable account, and when you sell to use the funds at retirement, you'd be taxed on the growth. More advantageously, young people should be using the power of tax-free growth in a Roth IRA account. Once you put the money in, the Roth IRA grows completely tax-free. There are eligibility requirements for using the Roth IRA, so please consult your financial planner (contact us) to discuss whether you're eligible to contribute to a Roth IRA and whether it's the right tool.
Is it Too Late?
For those of us who are no longer young (though we're young at heart), the natural question is, is it too late? The simple answer is, absolutely not. We may not have the luxury of time and may have to reset expectations, but we should start where we're at right now.
As author Karen Lamb once said, "A year from now, you will wish you had started today."
Building a Strong Foundation
While starting early is crucial, there are additional factors investors should consider:
Diversification: Don't put all your eggs in one basket. To minimize risk, spread your investments across different asset classes like stocks, bonds, and real estate.
Risk Tolerance: Understand your own risk tolerance and choose investments accordingly. Aggressive portfolios may offer higher returns but also carry greater risk.
Education: Continually educate yourself on personal finance and investing strategies. There are numerous online resources and financial planners available to help you on your journey.
Compound Your Knowledge
The good news is there are countless resources available to help young people embark on their investment journey:
Financial Literacy Websites: Websites like the National Endowment for Financial Education (https://www.nefe.org/) and Investopedia (https://www.investopedia.com/) offer a wealth of information on personal finance and investing. Faith & Finance (https://www.faithfi.com/) offer this and other other content through a Christian and Biblical lens.
Investment Calculator: Calculate the return rate needed to reach an investment goal with particular inputs. (https://www.calculator.net/investment-calculator.html)
Financial Planners: Here at Reach One Teach One Financial, we are happy to discuss your specific situation to help. Our sister organization, R1T1 Education, offers a financial health vitals service called The Jut (https://www.thejut.com/), where you can assess your financial health and talk to a Certified Financial Planner to answer questions about your situation. Remember, not all financial advisors are the same. Some are Bone Collectors, and you should run away.
Conclusion: The Future is Now
The power of compound interest is a gift that keeps on giving. Remember our example of Mike, Tom, and Buck. Be like Mike and Buck. Start early, invest consistently, and make sound financial decisions. You, too, can unlock the potential for a secure and prosperous future.
The secret to any successful investing is Time and Discipline.
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