This is a guest post by G.E. Miller, head author of the personal finance blog 20-Something Finance. It’s a nice companion to my article this morning about the extraordinary power of compound interest. Both articles are a part of Financial Literacy Month.
Before we fire off the gun to start the ‘Compound Return Marathon’, let’s cover some basics on what compound returns are and why you should care.
What is compound interest?
You probably became familiar with the term ‘compound interest’ when you first started placing money in your bank accounts. Most of us recognize compound interest as the interest we receive from holding money in a savings account, certificate of deposit, or other low rate of return investment at the bank. Any form of compound interest is great, but this post isn’t about avoiding depreciation in cash value by earning just enough to out-pace inflation with low rate returns (which is about all no risk interest accounts are able to do). Let’s discuss a different type of compound interest.
When you purchase index or mutual funds, you are often asked what you would like to do with any dividend or capital gains disbursements from that particular investment’s holdings. When you select that you would like to ‘re-invest’, you are, in effect, compounding your returns. The same goes for dividend producing stocks. You are offered the choice of receiving your dividend in the form of a cash payout, or re-investing the amount into more stock.
Why should I care about compound returns?
When fully harnessing the power of compound returns, you can save less, make more, and retire early. There is sacrifice. You will need to start saving at a time when many of your peers are getting takeout food every night, leasing vehicles they can’t afford, and buying all the latest tech gadgets. If you’re in your 20′s or 30′s, this post should instill a sense of urgency in you. If you’re a little older, you have some making up to do, but it’s not too late. Additionally, maybe there’s a young adult in your life whom you can help get off to a financial running start with the aid compound returns.
The Compound Return Marathon
Let’s take a look at five different retirement strategies in the form of five hypothetical “marathon” participants (based on personas that we are all familiar with) and crunch some numbers to see who wins. Before we test the strategies, let’s take a look at the rules:
- The average annualized rate of return for U.S. stocks was 13.4% from 1926 to 2000. The worst average annual rate of return for U.S. stocks in any 65 consecutive year period has been 8.5%. For this Marathon, let’s take the average between the two, and assume our participants are able to get a 10.95% return on our investments every year for each participant that invests in stocks.
- Our conservative participant invests in a CD, which will earn 5%, compounded annually.
- For simplicity, we’ll ignore taxes.
- Everyone invests until age 67, the projected official retirement age in the future.
And now, let’s meet the participants:
- Early Bird Bob: Bob didn’t follow the urge to blow his cash flow and ‘make up for it later’. He has decided to follow his own rules to utilize the power of compound returns. He invests $5,000 per year in domestic stock funds (earning 10.95% annualized) starting at age 20, and stopping at 40. Because he sacrificed early, he’s also able to stop investing 27 years before anyone else does.
- Conservative Carrie: Carrie invests $5,000 per year in certificates of deposit (earning 5% annualized) starting at age 20 until age 67. Carrie sees the value in compound interest and has the right idea in saving early. She could get a reward for her consistency, but the fear of a market crash paralyzes her willingness to invest in stocks.
- Live-it-up Larry: Larry invests $10,000 yearly in domestic stock funds (earning 10.95% annualized) starting at age 30. Larry discovered the power of compound returns after living it up in his 20′s, but regrets not discovering it 10 years earlier, so he is making up for it by doubling Bob’s yearly contribution amount.
- Late bloomer Bill: Bill invests $20,000 yearly in domestic stock funds (earning 10.95% annualized) starting at age 40, until age 67. Bill has a high income job and is trying to make up for lost time with huge contribution amounts. He has downgraded from a Benz to a Lexus and cut back from three times a week at the golf club to two.
- Mid-life crisis Melissa: Melissa invests $40,000 yearly in domestic stock funds (earning 10.95% annualized) starting at age 50, until age 67. Melissa spent most of her money throughout life to impress her friends, but since they all left her because she was too materialistic, she now has a load of time to make extra income to apply towards retirement. Is it too late for Melissa?
You can view the results of the Compound Return Marathon in a free Google Doc. Here you can see how much each participant was able to amass up through age 67. Additionally, you can see how much money they personally contributed to their retirement efforts.
Here’s how they finished:
- Early Bird Bob contributed $5,000/yr. for 20 years ($100,000 total contribution). His nest egg at age 67 is $5,938,625.
- Conservative Carrie contributed $5,000/yr. for 48 years ($240,000 total contribution). Her nest egg at age 67 is $940,127.
- Live it up Larry contributed $10,000/yr. for 38 years ($380,000 total contribution). His nest egg at age 67 is $4,644,805.
- Late bloomer Bill contributed $20,000/yr. for 28 years ($560,000 total contribution). His nest egg at age 67 is $3,168,398.
- Mid-life crisis Melissa contributed $40,000/yr. for 18 years ($720,000 total contribution). Her nest egg at age 67 is $2,005,735.
Now that the race is over, let’s see what we’ve learned.
- You’re better off starting late and taking risk than starting early and taking no risk. Being risk averse is dangerous in many ways. When looking at Conservative Carrie’s results, you’ll see that despite starting earlier than three other participants and investing every year, she wound up earning the least for retirement, in dramatic fashion. With that being said, starting early and welcoming a little extra risk can pay the biggest dividends.
- Even if you start extremely late (Melissa), you can still drastically impact your future. Despite investing only 18 years, Melissa is still able to triple her total contributions.
- Fully taking advantage of compound returns is your only opportunity to retire early. Take a look at all participants at age 50. Bob could realistically retire at age 50 and live off the interest, at least to get him up to retirement age and social security. None of the other participants stand a chance of retiring early.
- Compound returns are pretty darn powerful.Early bird Bob contributed much less than anyone else, and stopped contributing at age 40 (27 years before everyone else), yet ended up with over $1.3 million more than any other participant. He contributed much less, quit early, and still wound up beating everyone else easily. In fact, he almost made 60 times his original return. Compare that to only three times for Melissa, the latest adapter.
The Bottom line: If you’re not maxing out your contributions as early as you possibly can, you’re falling behind.
J.D.’s note: As with some of the commenters, I believe the 13.4% average annualized return isn’t realistic. I used 8% for my own article on compound interest this morning. I’ll do some research to explore the notion of compound returns over various time periods, and share the results in the next couple weeks.