It’s rumored that Albert Einstein once said, “Compound interest is the eighth wonder of the world. He who understands it earns it; he who doesn’t pays for it.”
As a CERTIFIED FINANCIAL PLANNER™ Professional with a long history in investing and working with time value of money concepts, I couldn’t agree more with this statement. However, I’m continuously baffled that today’s schools don’t make cash flow management and basic investing principles a standard graduation requirement.
As the father of four amazing children, I’ve taken on the responsibility of ensuring that my children understand basic and required money concepts. This understanding will not only be applicable for them now, but it will set them up for success in the future.
Compound interest is one of the most amazing variables in planning for your financial future. Furthermore, when you are young and have time on your side, compound growth becomes leveraged and even more critical to building your net worth.
In the example shown below, I have created a few different compound interest illustrations and financial games that I encourage you to work through with those who might benefit.
Double a Penny Every Day for One Month
Imagine that I offered you two choices, but you can only select one:
- I’ll give you $10,000 today or
- I’ll give you $0.01 today; then I’ll give you twice as much money every day (compared to the previous day) for the next 30 days. So you get to keep everything you collected during these 30 days.
Which option do you choose?
- Option 1 Results – straight forward, you get $10,000. Not bad for a day’s work!
- Option 2 Results – the payment you receive on the 30th day is $5,368,709! If you include the money you got to keep each of the previous 29-days, you’ve collected a total of $10,797,408. So it looks like option #2 wins!
John and Sally Start Investing $2,000 Per Year at Different Ages
Imagine John and Sally are both 19 years old, and they are debating whether or not they should begin investing for their future. They each have $2,000 available to invest on an annual basis, and their investment will grow at an annual rate of 10% per year.
- Sally starts investing $2,000 per year immediately at age 19. She continues investing the same amount every year for the next 7-years, then she stops and never invests again.
- John decides he’d rather spend his money and holds off on investing until year 8. Then, starting in that 8th year, when John is 27 years old, he begins investing $2,000 every year, and his contributions continue until he is 65-years old.
Based on this, would you rather have Sally or John’s future value at age 65?
- Sally’s Results – she has accrued $1,019,160 by the time she’s 65 years old. Sally invested right away, socking away $2,000 per year for 8-years (i.e., $16,000 total), all of which grew at a compound rate of 10% per year.
- John’s Results – he has accrued $883,185 by the time he’s 65 years old. John missed the first eight years of compound growth and instead spent the next 39-years saving $2,000 per year (i.e., $78,000 total), all of which grew at a rate of 10% per year.
The key takeaways here are simple. Compound growth can be impressive, especially when you have time on your side! I don’t know about you, but I’d prefer Sally’s investment, where she saved roughly 20% of what John put away yet ended up with $151,975 more in her portfolio at age 65.
The benefit of compound growth is something that simply shouldn’t be ignored. During strong economic and market growth periods, compounding becomes even more lucrative to the long-term investor.
At Birchwood Financial Partners, we work with our clients to help them feel empowered and knowledgeable about financial decisions every day. Please visit our website (www.birchwoodfp.com) if you are interested in learning more about our Firm, our team, our processes and services, and the clients we currently serve.