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The Joys of Compounding – Why to Start Saving and Investing Today.

In a physics lab I remember a certain experiment. A large wooden block is on the table with a scale attached. Similar to this:

Start pulling the block while your lab partner anxiously watches the reading on the scale.

 

As you begin to pull, the force measured on the scale increases, but the block goes nowhere. Keep pulling a little harder and still nothing. Then, all of a sudden as the force measured by the scale increases further, the block seems to “breaks free” and the force required to move the block suddenly seems to decrease as you pull it along the table.

 

It seems that the block requires a large amount of force to initially move, but once “broken free” it requires significantly less force to keep it moving.

 

[This experiment was hardly revolutionary. Leonardo Da Vinci had made measurements similar to this in 1480! As seen from his sketches below:]

 

What you have discovered is the difference between an object’s coefficient of static friction (When it is stationary) and kinetic friction (When it is moving). For most objects, its coefficient of static friction is much higher:

 

Image courtesy of Wikipedia

Image courtesy of Wikipedia

The moral of the story (and a tip that might save you a day of lectures in physics 101) is that:

 

It takes much more energy to get an object initially moving than to simply keep it moving.

 

More importantly, this principal applies to your retirement savings as well.

 

Getting The Ball Rolling

 

Let’s say you are 25 years old and you have hardly thought about starting to save for retirement.

How discouraging would it be to read the following headline? (Which was just published last week on thestreet.com )

Pretty sad right? If you can manage to save $10,000 a year you just need to save for… 200 years!

($2 million ÷ $10,000 = 200)

 

If that is not a source of “Static Friction” to starting an investment plan I don’t know what is.

 

After all, if the dream is so far out of reach… Why bother trying?  For all too many, the large numbers thrown around when talking about retirement cause them to shut down instead of motivating them to get started, until it becomes too late.

 

Or maybe your source of “static friction” was after being turned away by an investment advisor who has a large minimum account size. (Don’t worry – we have no minimum account size for clients)

 

Either way, the object of this post is to get you motivated to start today by seeing that even small amounts saved can add up over time thanks to another (and much more powerful) force in finance:

Compounding Interest.

 

 

The Joys of Compounding

To demonstrate the true value of time and interest, consider this example from Warren Buffett’s 1965 letter to his partners:

 

“One story stands out. This, of course, is the saga of trading acumen etched into history by the Manhattan Indians when they unloaded their island to that notorious spendthrift, Peter Minuit in 1626. My understanding is that they received $24 net. For this, Minuit received 22.3 square miles which works out to about 621,688,320 square feet. While on the basis of comparable sales, it is difficult to arrive at a precise appraisal, a $20 per square foot estimate seems reasonable giving a current land value for the island of $12,433,766,400 ($12.5 billion). To the novice, perhaps this sounds like a decent deal. However, the Indians have only had to achieve a 6.5% return to obtain the last laugh on Minuit. At 6.5%, $24 becomes $42,105,772,800 ($42 billion) in 338 years, and if they just managed to squeeze out an extra half point to get to 7%, the present value becomes $205 billion.”

 

Now unfortunately, none of us will likely have a 338 year time horizon for our investments. But Buffett's example demonstrates how powerful a force compounding is. With returns that are about what the stock market has returned on average over the last 100 years or so, $24 becomes $205 billion.

 

So what about a more realistic scenario? Let's look at a 25 year old today who can afford to save just $100 per month.

A typical 25 year old today more than likely has very little already saved, but will likely have 50+ years to watch their investments grow. How much would that $100 per month ($1200 per year) grow to if it compounded at 6% for 50 years?

 

To illustrate, I thought of a quick example consisting of 3 investors.

-          Investor 1 is a 25 year old who saves $100 per month

-          Investor 2 is a 50 year old who saves $500 per month

-          Investor 3 is a 60 year old who saves $1,000 per month

 

Assuming each investor achieves a 6% compound growth rate, who has the most money at age 75?

Investor 1 is young, saves little but has the advantage of time on his side. Investor 2 saves 5x what investor 1 does, but has half the time. Investor 3 saves 10x what investor 1 does, but with only a quarter of the time for their assets to grow.

 

Using our Compound Interest Rate Calculator we can see who comes out ahead:

Want to play around with these numbers yourself? Head over to our Compound Interest Calculator

A 25 year old with a 50 year time horizon saving only $100 per month (the red line in the chart above) eventually saves more than someone who can afford to invest $500 per month for 25 years (The blue line above)! That 25 year old also saves more than someone who can afford to save 10X what they are saving, but only for 15 years!

Think about that for a second. Having a longer time horizon is more important than being able to save 10x the amount of money for this investor.

 

But very few save like this young investor. Very few ever start saving at all.

 

The Long Road to Financial Freedom

 

The “static friction” that overcomes so many young savers and investors comes from several sources. We talked about being overwhelmed by the large numbers above. Another force against young savers is caused by looking at their accounts every month and expecting to see dramatic gains. It’s hard to imagine $2 million in your retirement account when your account has only gone up $100 last month.

 

But the beauty and power of compounding interest takes years, decades even, to take hold.

 

 Let’s look at our thrifty 25 year old’s situation in more detail:

 

·         The interest gained on our investor’s account after the first year is $72. (...Wohoo…)

·         It takes our investor 7 years to finally break the $10,000 milestone.

·         It takes our investor 30 years to break the $100,000 barrier.

 

But, after decades of slow growth, the magic of compounding interest starts to go to work:

 

·         After year 12, the annual interest on our investor’s account is now more than the $1200 in annual contributions!

·         After taking 7 years to save up the initial $10,000, past year 37 the investor earns more than $10,000 in interest alone each year!

·         After taking 30 years to get the first $100,000, our investor hits $200,000 just 11 years after reaching $100,000!

·         After taking 41 years to reach $200,000, our investor reaches $300,000 on his 48th year, just 7 years after reaching $200,000!

 

So next time you think to yourself, “I’ll just wait until I can afford to save and invest.” THINK AGAIN! That little bit you have left over can be put to good use. It’s not that the smaller sums you can afford today will fully fund your retirement, but the $350,000 that $100 per month creates for this investor is certainly a good start.

 

When Buffett wrote his letters to his partners, he also usually included a compound interest table, such as this one from the same 1965 letter:

A huge reason that Buffett has amassed the wealth he has today is because he saw what the value of a dollar today could be decades in the future. He didn't buy fancy cars, get expensive haircuts or live in a fancy house until he was much older. The savings from buying and living in a $31,000 house, driving an old car and getting cheap haircuts for decades is now obvious.

 

Breaking Free

 

The secret for future financial freedom is not being able to save tens of thousands today. For investors with time on their side, even small amounts of money can add up to tremendous sums decades in the future.

Play around with our interactive compounding interest rate calculator to see for yourself.

 

Buffett referred to compounding interest as the 'snowball effect', and he said:

"Life is like a snowball.
The important thing is finding wet snow,
and a really long hill."

 

So don't wait! Let us help you get started TODAY. Our services range from financial planning where we help you budget and save responsibly to full service investment management, where we manage your investment portfolio for you.

Even with just small sums of money today you can break free and start yourself on a much more pleasant path to retirement.

 

 

 

 

 

 

 

Matt HyllandComment