The Power of Compounding
In this article, I am going to use a case study that is usually discussed on the first day of a personal finance class in high schools. Let’s consider these two individuals and their circumstances.
Julia
Starts investing at Age 22
Invests $400* every month for 10 years and stops contributing then.
Earns 10% Interest Rate
Invests the yearly amount ($400 X 12 = $4,800) in Jan of each year.
Total amount invested = $400 X 12 X 10 = $48,000 over 10 years
Ben
Starts investing at Age 32
Invests $400 every month for 30 years until Age 62
Earns 10% Interest Rate
Invests the yearly amount ($400 X 12 = $4,800) in Jan of each year.
Total amount invested = $400 X 12 X 30 = $144,000 over 30 years
*10% of median salary assuming the starting salary is $48,000 per year.
Who do you think will have more money at age 62? Spoiler alert! It’s Julia and the number is not even close. Julia will have $1,707,329.12 and Ben will have $960,661.28. Don’t believe it? Watch this video for yourself.
The reason I chose to write this article even though these types of cases are discussed commonly in personal finance classes is because I wanted to highlight the lessons that I learnt from this case.
This fact bears repeating. Julia invested a third of the amount that Ben invested and still has 78% more money than Ben at age 62. That is an astonishing fact and highlights the power of compounding.
Another feature of compounding that I am a big fan of. It takes Julia 11 years to get to the first $100K but then the time gets smaller and smaller (8 years for the 2nd $100K, 4.5 years for the 3rd $100K, 3 years for the next $100K and then so on).
A feature of compounding is that your money is earning money. It is like having an extra family member that is contributing towards your family wealth. The assumption here is that both of them are investing 10% of their salary every year. At age 50, Julia’s portfolio is earning a higher return than Julia’s yearly salary.
Think about the previous lesson for a minute. Here you are, working 40 hours a week, Monday-Friday from 8 AM to 5 PM and on the other hand your money is earning more than what you make in a year without any effort on your part (well, you did make the effort of contributing every year and then had the patience to leave it alone.)
It bears repeating that this process of compounding will only work, if you leave this money alone for 30 years (like in your 401K, IRA or other retirement accounts).
Lesson number 5 and 6 kind of go together. In this hypothetical scenario , we assumed that they are able to generate 10% returns every year. In real-life, this rarely happens on a consistent basis. The returns on your portfolio will fluctuate, wildly sometimes, but overall you can expect about 10% returns if you just let the money sit there and do nothing (except contributing every year). Here is an example investment that has given about 11% returns for the last 44 years (https://investor.vanguard.com/mutual-funds/profile/performance/vfinx). My personal annual return on my 401K for the last nine years since 2012 is an average of 11.71% per year. I started tracking these in 2012 and before then I did not pay attention to what my returns were and where my money is invested (what a huge mistake!). These are the results of my 401K portfolio where I am not allowed to invest in ETFs and individual stocks. My individual brokerage and IRA account returns are much better where I have more flexibility in choosing investments.
If we change our assumptions and make the interest rate 9% in our calculations, Julia will have $1,218,974 (short by almost half a million dollars). On the other hand, if we raise the interest rate to 11%, she will have $2,385,910.67 (beating the 10% number by $678,581.55). Why am I bringing this up? Cost of these investments is really important. Pay attention to the expense ratio of funds where you decide to invest. It should be close to 0%. Sometimes, we see expense ratios of almost 1%, even 2% and although they look like a small number, but even a 1% return either way can mean a difference of hundreds of thousands of dollars over time.
These were just hypothetical examples and we arbitrarily decided to have Julia contribute for only 10 years and then stop contributing but remember, in real life you don’t have to stop at age 32. You can keep contributing until your retirement age and you can imagine what that will do to total portfolio value. In fact, you don’t have to imagine. Julia will have $2,575,857.56 if she keeps investing until age 62.
We made another assumption, that the amount of their investment will stay the same over 30-40 years. But, in real life, you get raises (hopefully!) so you can increase the contribution every five years or so. Imagine what that will do to your wealth.
I left this lesson for last because I believe this is the most important lesson. Start as early as possible. You can see in this example, by starting early Julia came out ahead even when Ben invested three times more money than her. Many times, I talk to people and they keep pushing investing off because they want to wait until they have a sizable sum to invest. You can start by investing a small sum such as $50 per month. You don’t have to wait until you have thousands of dollars to invest. The commissions are zero these days so you can start investing at no cost. I know this because I had the same mentality. I did not start investing through my taxable brokerage account until age 34.
I can think of a few other lessons but I am going to leave this blank and ask you readers, what other lessons can you think from looking at this case study?
As always, any feedback is welcome and feel free to write comments below.