How compound returns favor the young

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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Investorial
Investorial
14 years ago

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.

J.D.
J.D.
14 years ago

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.

VinTek
VinTek
14 years ago

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… Read more »

Robert Allen
Robert Allen
13 years ago

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… Read more »

marisa
marisa
13 years ago

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!

will
will
12 years ago

Nice article on Compund Interest, it pays you to start early and stay with it.

Estrela
Estrela
12 years ago

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,

33NW66
33NW66
12 years ago

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,… Read more »

Drew
Drew
12 years ago

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?

Chris
Chris
12 years ago

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.

JORGE
JORGE
11 years ago

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…??

ben
ben
11 years ago

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.

tas
tas
11 years ago

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

marc
marc
11 years ago

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.

Nick Thacker
Nick Thacker
9 years ago

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… Read more »

Albert
Albert
6 years ago

I have about 23 thousand in a 401k, and haven’t add anymore money to this in about 15 years. Should I roll into Roth IRA and if so, what would be my return in 20 years. Thank you

Ronald Anderson
Ronald Anderson
5 years ago

Hi, I am 21 years old and really want to start building my wealth and snow ball effect this very moment. I need guidance and a great plan to follow for about 34 years. Will anyone be able to help me on this wealth building journey ?

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