The Positive Basic Argument for Investing

Previously, we covered that it is essential to invest your money so that it does not sit idly as its value erodes.  Being the eternal pessimist, I naturally presented the negative view of the time value of money first.  But the true fun in investing comes to light when we view the time value of money from a positive perspective.

The Power of Compounding
One of the first lessons in most finance courses involves the time value of money and the power of compounding.  There are some formulas involved, but chances are you don’t care to memorize them and there really is no need to.  They can be replaced with common sense thinking that tells you that if you have more money stashed away to collect interest on, you will earn more money.  Reinvesting your earnings gives you a larger basis on which you can earn even more.

Say you socked away $1000 and managed to find a Certificate of Deposit paying 5% interest a year.  At the end of one year you would have $1050.  If you kept those earnings invested at the end of two years you would have $1102.50.  Your earned $50 earned you an additional $2.50.

The Rule of 72
An easy way to remember the effect of compound interest is the rule of 72.  If you want to see how long it would take an amount of money to double at a particular annual interest rate simply divide 72 by your number.  For example, at 8% it would take about 9 years for you to double your money (72% / 8% interest = 9 years).  Similarly, if you would like to find out what interest rate you would need to double your money in a certain amount of time you would divide 72 by the number of years.  To double your money in 6 years you would need an annual interest rate of 12% (72% / 6yrs = 12% interest).

Next Step : Get Rich Slow

Armed with the power of compounding we can get to work on applying the principles.  Let’s say your name is Joe and you’re 25 years old.  As a New Year’s Resolution you have decided to save $100 a month, every month.  The chart above shows two scenarios.  In the first scenario, Joe, you’ve decided to just put the money away under your mattress.  At the typical retirement age of 65, you have managed to save $48,000.  Not too bad for just $100 month.

Now, Joe, let’s wise up and invest our money.  Say you can average an 8% return every year until retirement.  This may seem like quite a stretch with the current market environment, but not unheard of and actually quite achievable historically.  That $100 a month grows to nearly $350,000 at age 65.

Now Joe, let’s get smart and ambitious.  In 30 years, saving just $200 a month at an 8% rate of return, we end up with nearly $700k.  If we can manage better returns, at 10% you’ll end up with about $1.3mil and at 12% a $2.4mil.  Not too shabby, Joe Cool.

Driving It Home
The charts above demonstrate how much just a small difference in returns leads to a fairly big difference in the long run.  These are all important points to keep in the back of your mind as we continue to learn about investing.  As we’ve mentioned before, your two worst enemies are inflation and fees, which are also doing some compounding of their own.  Regardless, the power of compounding teaches us a great lesson: Invest early and invest often.

Tuesday, December 23, 2008, 01:57 | posted in explained | 3 comments »