Sunday, July 15, 2012

Rule #1 The Power of Compounding - Earlier is Waaaay Better!

When I was in Grade 10 math, Mr Gunter once put up a handmade chart that showed an example of how compounding interest worked.  The first scenario was for a person named Gordon, who at the age of 18 started saving $2000 per year and managed to get a 10% return on it each year. He continued to save $2000 every year and placed it in the same investment vehicle until he was 28 years of age.  He then allocated his money on other things in his life such as a buying a house, starting a family, saving for his kids' education etcetera and etcetera.  He never touched the money in the investment account.  That would be his retirement account.

At the age of 65, Gordon would have about $1.3 million in his account.  Wait a minute Mr. Gunter, can that be right?  Yes, it is! Its the power of compound interest Ryan, and Einstein called it the 8th Wonder of the World.  Its just that great!  This was one of those "Eureka!" moments for me. $2000 isn't that much to come up with each year... about $175 a month, and to think that I could just do it for 10 years and then I'd be set, well sign me up.  But, maybe I will buy that used car I've been eyeing up... it only costs $2500, I will start it next year... or maybe after I am done University, or Grad School, or after I've traveled the world.  Yeah, thats it, I will wait 'til I am a little more established before I start saving and investing.

Then Mr. Gunter showed us a second scenario.  This time he put up a chart of Gordon's friend and classmate, Simon. Simon waited until he was out of school and established in his career before saving and investing. He had a nice car, was renting a sweet condo, and dressed very smartly.  Simon saved $2000 a year starting at age 28 and then continued to save the same amount every year that he could. He had waited a little longer to get started at investing, but would contribute longer towards his savings and investing, perhaps until he was 65 and ready to retire. He too would get a 10% return and not touch the money in this account as this money would be for his retirement.  At the age of 65, Simon would have only $800000 for his retirement. Not too shabby, but still about half a million dollars less than Gordon.

So Gordon saved and invested $20000 for his retirement and it was worth $1.3 million at age 65. Simon saved and invested $76000 for his retirement and it was only worth $800000 at age 65. Simon put up almost 4 times as much in savings as Gordon, yet finished half a Milsky lower. The difference of course is the time factor... compounding needs time to work its magic and the longer you have it working for you, the bigger the paycheque is at the end of the investment period.

This example that Mr. Gunter showed us in class has stuck with me since that day, and I owe him a big thank-you for showing it to me.  It wasn't part of the curriculum (no money smarts strategies are) but he felt it was one of those things we just ought to know.  Its one of the most important money lessons I've learned: To start as early as possible and let the compounding work its magic for a long time.

1 comment:

  1. What I do is only have in savings (besides emergency fund mind you) what you will need to spend in six months to a year. Anything further than that dump in stocks.