In an earlier entry about the cost of waiting one year to begin investing for retirement, I posted a chart from AllFinancialMatters that demonstrated the power of compound returns. Vintek posted a math exercise related to the subject.
I got this from a book called The Random Walk Guide to Investing by Burton Malkiel. It’s a book I recommend, and I’ll eventually talk about it in the forum. Here’s the exercise:
William and James are twin brothers who are 65 years old. 45 years ago (at the end of the year when he reached 20), William started an IRA and put $2K in the account at the end of each year. After 20 years of contributions, William stopped making new deposits but left the accumulated contributions in the IRA fund. The fund produced returns of 10% per year tax-free. James started his own IRA when he reached the age of 40 (just after William quit) and contributed $2K per year for 25 years, making his last contribution today. James invested 25% more money in total than William. James also earned 10% on his investments tax-free. What are the values of William’s and James’s IRA funds today?
Vintek sent along the answer in a spreadsheet. It’s eye-opening.
William has $1,365,227. James has $218,364. James invested 25% more than William, but through the magic of compounded returns, William’s IRA fund is worth more than six times as much! For some real fun, download the spreadsheet and plug in your own numbers. I’m having to contribute $5,000/year because I didn’t start in time. How about you?
(Note that the 10% assumption used in the charts and in the spreadsheet is arbitrary and for illustrative purposes only. An 8% return-on-investment is more realistic over the long term, and interest rates on CDs are half that. Still, the same principle applies regardless the rate, as long as the rates are consistent between sample cases.)
You twenty-somethings: I know that retirement seems a long way off, and you probably wish I would write about how to save money on mortgages or how to use coupons at the grocery store. But this is important. Force yourself to save for retirement. It may hurt, but it’s not going to hurt for long. And when you’re old like I am, you’ll be glad you made the decision. If you will just invest $2000/year for twenty years starting at age 20, you’ll set yourself up for life!
A commenter at AllFinancialMatters writes:
Don’t ever try to convince yourself that you can make up for not saving for a few years by saving later. It will snowball. You’ll establish a lifestyle that depends on too much of your income to ever make up for lost time. But if you didn’t save enough last year, resolve to find the extra money somewhere this year to make up for the lost time. When you are in your 40s like me and looking back, you won’t have regrets about your retirement savings.
Amen.
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Remember though, that compound interest works for interest-bearing investments only. Compound returns for investments that have the opportunity to deliver negative returns can negate the effects of compounding.
So theoretically, if I started 10 years earlier and I get into a bad mutual fund for 5 of those years and somebody goes and earns solid 6, 8% annually but started 10 years late. It won’t be the same results!
I blogged about it at my blog, Investorial.
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Vince makes some excellent points, and notes some poor word choice on my part again. I’ll go back and fix that.
In general the principle still applies. Markets do fluctuate, but regular investments (dollar-cost averaging) compensate for these ups-and-downs and help you obtain consistent grownth. Scheduled investments over the long haul pay off. They don’t actually earn you compound interest, but the principle still applies.
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I agree that the principle of compounding still applies. Although negative returns can and do occur (we had some really bad years 2000-2002 and we just had a couple of really bad weeks), the average return on blue chip stocks runs about 11% (1926-2001) and about 12.4% for small caps.
Another tidbit, when the NYSE celebrated its 200th birthday in 1992, it could report that a person who bought shares in a all of the companies on the exchange on *any* day in its history would have beaten bonds and savings account over virtually any period exceeding 20 years. What does this mean? That if you purchase an index fund covering the total stock market, that compounding over the long term is going to pay off…big. Compounding does occur; it just isn’t in the form of interest.
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[...] I love this advice. It demonstrates again how compound returns favor the young. If you are in high school — or college — resist the urge to party with your peers. If you can exercise the mental fortitude to save money for just a few years, you can practically guarantee comfort in your retirement. A short burst of dedication in your youth can prevent an adulthood of struggle. (Another MSN Money article outlines six steps to becoming your own boss, a sort of how-to guide for young entrepreneurs.) [...]
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[...] My advice for Casey is this: If you have a burning passion to make these sorts of plans succeed, then pursue them with only a portion of your finances. Follow tried and true personal finance wisdom with most of your money. Take 90% of what you earn, and do the boring stuff with it: pay off debt, start an emergency fund, invest for retirement. You are so young right now, that if you would invest just $5000 each year until you’re 50, you could retire then as a millionaire. (Assuming 10% returns.) This is with almost no risk. Why try to get rich all at once? Why not ride it out? [...]
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[...] As a result, more young people are relying on their families for support, both for housing and for money. Young people are also saving less than before, which alarms me. The article quotes several people who essentially complain, “I cannot afford to save.” I used to believe this, too, but I was wrong. I’m still paying the price for being wrong. Most people can afford to save something, even if it’s just $50 a month. Remember: compound returns favor the young. [...]
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[...] I’m starting a series of pet peeves that I find in almost all personal finance blogs. One of the most amazing things you’ll read is how some small amount of money compounds at 10% over 30-40 years to some huge number. Here are just a couple of examples from some blogs that I respect quite a bit (they are both truly great writers). [...]
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I began an IRA for my son in 1990 when he joined the army and went to Iraq($2,000 per year contributions )…later I paid the income taxes and we converted it to a Roth IRA; at that time the mutual fund IRA was valued at approx $25,000…today I added an additional $1,000…now I am up to $3,000 annual contibutions which I plan to continue indefinately. The value of the IRA is presently $78,000. He is 36 years old. I expect the value, if we continue to contribute or not, to be over $1 million by his retirement age of 67 years.
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[...] If you’re young, you probably don’t think you need to start a retirement account. You’re wrong. No matter how old you are, now is the time to begin saving for retirement. Why? Because compound returns favor the young, and in a big way! (Here’s an illustration of the cost of waiting one year.) In The Millionaire Next Door, David Bach writes: The single biggest investment mistake you can make [is] not using your [retirement] plan and not maxing it out. [...]
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[...] retirement could be one of the biggest financial mistakes you’ll ever make. Compound returns favor the young. Time is money. Invest now and your 40-year-old self will be grateful. But where do you [...]
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[...] spring I wrote about how compound returns favor the young. Vincent, a GRS reader, contributed a simple spreadsheet with which you can explore [...]
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I’m a total klutz with Excel – could you explain how to plug in your own numbers (e.g. age of initial investment, and annual contribution), and maybe how to change the ROI to 8%? (What I’d really like is one column that shows an 8% ROI and another with 10%.)
Thanks!
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[...] wrong. No matter how old you are, now is the time to begin saving for retirement. Why? Because compound returns favor the young, and in a big way! (Here’s an illustration of the cost of waiting one year.) In The Automatic [...]
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Nice article on Compund Interest, it pays you to start early and stay with it.
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[...] mean you should wait until after you graduate before you get started? I don’t think so, as it generally accepted that the sooner you start the better compound interest will treat you. Having an Individual retirement fund (IRA) can help get started and when you get a job after [...]
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[...] Start saving now, not later. Don’t worry about whether the market is high or low — just begin investing. “Trust in time rather than timing,” Malkiel writes. “The secret to getting rich slowly (but surely) is the miracle of compound interest.” [...]
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I liked you article. My question is how do I open an compound account? Can you give me some indications on how to start? Thanks,
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Saving money for retirement / setting up an IRA is easy. The hard part is to find investments that return 10% annually! The author tosses this figure out there as if such investments were simple and commonplace. If it were easy to find 10% annual return investments we’d be living in a world of millionaires. Only banks and credit card companies can expect that kind of return on their investment. For average Janes expect 3-4% on mutual funds maybe 6% in a good year. Most people dont have time or interest in learning about or tracking stocks. So for them, the 10% annual return is a pipe dream.
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[...] need to save compared to someone middle aged who is just starting to save. It’s all part of the miracle of compound interest. Here are some retirement saving [...]
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In my roth portfolio I currently have only mutual funds. I guess the only compounding I have been experiencing for the last couple years is only from the reinvestment of dividends and capital gains.
But how do I lock in the appreciation (Interest)that I show from my mutual funds increasing in NAV….by manually selling and reinvesting myself? This is where I am unclear on the compounding effect, have I missed out on the last 4years by being only in mutual funds?…can someone please advise?
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I’m about to turn 31. I contributed to an IRA when I was 22 and 23, but I haven’t since then. I’ve been putting my money into 401(K) accounts.
Have I screwed myself? Am I missing something major by doing it this way? I know any saving is better than no saving, but ought I be contributing instead to an IRA? I can’t afford to contribute significantly to both.
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Yes, everything about the compund interest and saving money and investing it in these kinds of markets sounds good, BUT, where do we find the 8% return markets??? CD’s are easy to get: go to the bank and that’s it. BUT where do we go or who do you guys suggest to invest our money at? What mutual funds, what ocmpany, etc…??
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After this crash, do you still believe market?
I started invest in both 401k and Roth and just left money for my food and daily life. What I left? My 401k is down 40 to 50% and total value is less than my contribution and emplyer matchs. And roth IRA is same. I lost about 20% of principle.
Where should we invest? I experienced 2001 and this. Lost everything gained between.
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Can some one repost that spread sheet the link doesnt seem to be working i really looking for a spreadsheet to calcuate the numbers for me.
thanks
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Also, this doesn’t take into account inflation – so around 4-5% should be taken off the returns to get the real value in 40 years. Don’t be fooled. 1 million in the spreadsheet in 40 years will be like having only a few hundred thousand today.
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A very good primer on Roth IRAs. It’s important to note, however, that Roth IRAs (and most other standard retirement accounts) are basically simply a “folder” in which you are able to put specific instruments and securities (and cash) or purchase funds.
In the example you gave, Malkiel mentions that each brother “earns 10% on their money.” The key here is that each earned money in a tax-free account (the Roths) because they invested that money in something that earned that return. If they had only left cash in their Roth IRAs, they would only have the principal amount they put in (possibly minus inflation), though it would definitely be tax-free money.
What should you put into a Roth IRA? What are some ways you all have made significant returns in your retirement accounts?
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