I love reading email from Money Boss readers. I’m not always great at responding, but I do read every message you folks send me. And sometimes I do respond — occasionally at length.
This week, I received two fun messages. First, Rae responded to the first email of the Money Boss crash course:
I just signed up for your Money Boss newsletter. I am replying in regards to letting you know what my financial goals are at the moment. I would just really like to share this with you, especially since I am only 19 years old and thinking about the goals just seems quite overwhelming.
It’s always awesome when young people come to Money Boss (or any other financial resource). So much of financial success involves good habits practiced over long periods of time. If you’re 59 years old and just beginning to think about financial freedom, your situation is tough. But if you’re 19, you have an extra forty years to set yourself up for financial success.
A lot of this is due to the magic of compounding. Over the short term, your investment returns don’t help a whole bunch. But over the long term? Over decades? Wow! Compounding can make a huge difference.
Another Money Boss reader named Anders also wrote last week to testify to this very fact:
I used to save money in funds without knowing more than it gave a better interest than ordinary savings accounts. Then a few years ago I came across a book that explained compound interest and showed graphs of how it works. I was blown away by the idea!
I think, for me, that was the biggest impact on my way of thinking about savings and it got me more interested in the stock market too. So in my opinion, the things people who don’t know too much about savings/investing need to hear is about how compound interest works and how the stock market works.
We’ll leave “how the stock market works” for another day. (If you want to know more right now, check out my articles on stock market returns and how to invest.) Today I want to look at why some folks consider compounding to be the most powerful force in the universe.
The Power of Compounding
On its surface, compounding is innocuous — even boring. How much does it matter if you start saving now? Will it really affect what you can spend in the future?
To illustrate the power of compounding, I spent far too much time playing with spreadsheets. (Seriously. My office-mate Kathleen managed to get like three major projects done in the time it took me to generate the following numbers and graphs. But I had more fun.)
Note: All of the numbers that follow are based on certain assumptions. For each of the three asset classes — stocks, bonds, gold — I’m using the long-term average real return: 6.8% for stocks, 2.4% for bonds, and 1.2% for gold. That’s what these investments return over decades (not year to year) after accounting for inflation. However, it’s very important to undertand that average is not normal. Returns can (and do) vary widely from year to year.
First up, here’s a basic look at compounding in action. This table assumes you invested one dollar into each of stocks, bonds, and gold. Based on historical averages, I’ve calculated how much your dollar would have grown to at the end of each year for fifty years:
As you can see, compounding doesn’t really do much during the first few years. After a decade, your $1.00 would nearly double if invested in stocks. (Remember, this is inflation-adjusted. The nominal number would be greater. But this is what your dollar would be worth.) If invested in bonds, that $1.00 would grow to $1.27. And if you invested in gold? That $1.00 would grow to $1.13. (For the record, my research shows that real estate offers long-term returns similar to gold. Others say real estate returns are worse than gold.)
The longer your money remains invested, however, the more powerful compounding becomes. After ten years, your $1.00 in stocks grew to nearly $2.00. Afters sixteen years, it will grow to nearly $3.00. In 20 years, it’ll grow to nearly $4.00. In 24 years, it’ll be worth more than $5.00. From there, the growth becomes even more rapid. By year 40 — which, yes, is a very long time — you’re earning more than a dollar every year. [Read more…]