Monday, June 6, 2016

The Power of Compounding

Objective: To start understanding the power of compounding

Let us start our investing articles at the very beginning, because it’s a very good place to start. When you are young, funding your retirement is often far from your mind. It’s much more enjoyable to use your money to buy things that will improve your standard of living right now because you have plenty of time to amass your fortune for retirement; it’s too early to start worrying about that, right? 

Wrong, it’s never too soon to start planning for your retirement because the earlier you begin investing, the better your results will be. All because of the principle of compounding. Compounding is the growth of earnings. 

For example:
  • $1,000 invested in January could grow by 3% between January and June to a total account balance of $1,030.
  • The investor now has $30 in earnings in addition to the initial $1,000 investment.  ($1,000 x 1.03 = $1,030)
  • Then the account balance could grow by 4% between July and December.
  • The June account balance of $1,030 would grow by 4% during the second half of the year.  ($1,030 x 1.04 = $1,071.20)
  • When figuring the July-to-December growth, we begin with the $1,030 figure that includes earnings – so we are making money on our earnings.

Compounding Earlier is Better

Without examining the numbers, many people believe it's relatively easy to recuperate from a late start in saving for retirement. Misinformed investors might theorize that a little larger annual investment will offset a later start. To understand the difference between an early start and a late start, look at this scenario and accompanying graph.

Early Earl begins investing $150 at the end of each month when he is 18 years old. He does all of his investing in a steady index fund that averages 10% growth each year. His goal is to retire when this account reached $1,000,000. Plugging these numbers into my financial calculator it looks like Earl will retire just before he turns 60 after only having invested $75,391 into the account.

However, Earl’s younger twin, Procrastinatin Pete decides that he can’t afford to spare an extra $150 yet because he needs to be able to afford the lease on his new car. So he decides that he’ll start investing when he comes across some extra money. Ten years later, at age 28, he is finally ready to open his future retirement account. At this point he is only $29,500 behind his brother and he decides to invest twice as much as his brother to make up for the lost 10 years. So, he invests $300 at the end of each month into the same fund as his brother. So how much does Pete have in his account when Earl retires? Answer: $756,713 after having contributed $115,200. And at this rate he has almost 3 more years before he retires. 


The big-picture lesson from this simplified example is that market growth being equal, someone who starts investing later will invest more in order to earn less than a person who started earlier!! More years of compounding will generally make a huge difference.


But where do I start?

I remember when I was just starting my senior year in college I had this dilemma arise. I knew the principles of investing and how to calculate horrendously intricate time value of money scenarios and see the power that could come from investing early, but I was 24 and hadn’t invested anything for myself. I remember calling one of my older sisters and telling her that my wife and I had over $50,000 in cash that we knew that we wanted to start investing with but didn’t know how, and seeking her advice of how to get started. I don’t remember all of the details of the conversation but a few months later we had the $50k set aside for a down payment on a house that we bought a few months after graduating college and a Vanguard fund for the rest where we were syphoning as much money into as we could each month. 

After realizing how easy it was to set up a Vanguard account I feel so foolish for waiting until I was 25 before I opened my first account. I wish that I had taken advantage of my tax exempt status while working through college and been investing in a Roth IRA for those 5 year. But I didn’t so all I could do was hit the ground running from where we were at since starting at 25 was better than starting at 26.

At my first job out of college we started investing in the company sponsored 401(k), in addition to our Vanguard account, at 12% of my income (roughly $7,000 per year). And now, almost 3 years later, we are investing 17% of my income into our 401(k) and collecting the 6% company match which means that we are currently putting roughly $13,845 into our retirement account each year, and have amassed just a hair under $30k in almost 3 years. So if I were to stop contributing to this account and just let it grow until I can start taking it out of my 401(k) it will have grown to over $250,000 dollars (assumed a conservative growth rate of 6% annually).  

Please note, I don’t divulge these numbers in an attempt to brag or build myself up but out of a desire that you will find hope and encouragement from it and see that you can do it too. No matter where you are at, START NOW! If your company has a 401(k) then go talk to HR or do whatever you have to do to start using it, that’s the easiest way to invest. The next easiest is to go to Vanguard.com and open an account. Please contact me if you have any questions about how to get started and I’ll gladly help you get going.