Is the “Magic of Compounding” really magic?
Well…kind of. At a minimum, understanding the power of compounding is the most important concept in investing. Consider the following question:
“You can have $1 million right now or just a penny today, but I’ll double that penny every day for the next month? In other words, 2 cents tomorrow, 4 cents the next day, etc. Which would you choose?”
If you answered I’ll take the $1 million right now… congratulations! You have a million dollars! Only, you just left a lot of money on the table. A penny doubled every day for 30 days will actually add up to a haul of over $10 million! For a 31-day month, you’d have over $21 million! Compounding is that powerful.
The “Rule of 72” is also a good “rule of thumb” to remember. I learned it in freshman year Economics on the first day of class (obviously, my professor thought it was pretty important, too!) Earn 8% per year and you double your money in 9 years (8 X 9 = 72). At 9% a year, you double in 8 years. 6% a year, doubles in 12 years and earning 12% a year, doubles in 6 years (12 X 6 = 72). I hope you get it; the point is that very reasonable rates of return can help you start doubling your money really quickly.
And the sooner you start, the better.
A few years ago, I was asked to teach a weekly class on investing to a group of ninth graders from Harlem. With no money to invest and still years away from a good paying job, most teenagers don’t care about investing. I wanted them to. I’m pretty sure they just wanted to go to lunch. Still, taking a cue from my college professor, the first day of class I handed out loose-leaf binders with two charts on the front cover.
One chart had a column of numbers labeled “Investor A” at the top. In this first chart, Investor A invests $2000 each year into a retirement account starting at age 26. This same investor continues to make annual contributions to his retirement account until age 65 achieving a return of 10 percent per year on his investments. That works out to 40 annual contributions of $2000.
In the next column, “Investor B” begins at an earlier age. Investor B starts investing $2000 each year at age 19 and also achieves a 10 percent annual return on his investments. But Investor B only contributes $2000 each year for 7 years and stops contributing at age 26 (just when Investor A is getting started). That’s only 7 annual contributions of $2000.
At age 65, who ends up earning more money? Investor A or Investor B? The surprise is that Investor B, the one who made just 7 annual contributions when he was young and then never contributed again after age 26, ends up earning more—$930,641 to be exact. Investor A, who diligently made contributions each year for over 40 years, ends up earning less—$893,704. Not bad for Investor A, but not my point.
The point is this: When it comes to saving, investing and the power of compounding, starting earlier is better——a lot better.
Then again, if you’re starting late, don’t worry. It’s more important to start than anything else. At age 65, Warren Buffett had “barely” $3 billion. Now, at age 90, it’s over $90 billion. In other words, over 95% of his net worth was earned after age 65. Yes, the power of compounding is important. But you can’t start compounding until you actually get started!