The power of compounding *chart*

[maxter]

This is from my favorite financial website: Richard Russell's Dow Theory Letters.


For the average investor, you and me, we're not geniuses so we have to have a financial plan. In view of this, I offer below a few items that we must be aware of if we are serious about making money.

Rule 1: Compounding: One of the most important lessons for living in the modern world is that to survive you've got to have money. But to live (survive) happily, you must have love, health (mental and physical), freedom, intellectual stimulation -- and money. When I taught my kids about money, the first thing I taught them was the use of the "money bible." What's the money bible? Simple, it's a volume of the compounding interest tables.

Compounding is the royal road to riches. Compounding is the safe road, the sure road, and fortunately, anybody can do it. To compound successfully you need the following: perseverance in order to keep you firmly on the savings path. You need intelligence in order to understand what you are doing and why. And you need a knowledge of the mathematics tables in order to comprehend the amazing rewards that will come to you if you faithfully follow the compounding road. And, of course, you need time, time to allow the power of compounding to work for you. Remember, compounding only works through time.

But there are two catches in the compounding process. The first is obvious -- compounding may involve sacrifice (you can't spend it and still save it). Second, compounding is boring -- b-o-r-i-n-g. Or I should say it's boring until (after seven or eight years) the money starts to pour in. Then, believe me, compounding becomes very interesting. In fact, it becomes downright fascinating!

In order to emphasize the power of compounding, I am including this extraordinary study, courtesy of Market Logic, of Ft. Lauderdale, FL 33306. In this study we assume that investor (B) opens an IRA at age 19. For seven consecutive periods he puts $2,000 in his IRA at an average growth rate of 10% (7% interest plus growth). After seven years this fellow makes NO MORE contributions -- he's finished.

A second investor (A) makes no contributions until age 26 (this is the age when investor B was finished with his contributions). Then A continues faithfully to contribute $2,000 every year until he's 65 (at the same theoretical 10% rate).

Now study the incredible results. B, who made his contributions earlier and who made only seven contributions, ends up with MORE money than A, who made 40 contributions but at a LATER TIME. The difference in the two is that B had seven more early years of compounding than A. Those seven early years were worth more than all of A's 33 additional contributions.

This is a study that I suggest you show to your kids. It's a study I've lived by, and I can tell you, "It works." You can work your compounding with muni-bonds, with a good money market fund, with T-bills or say with five-year T-notes.

[Sternchen]

Wow!!! I need to find the German equivalent of something like this! I would love to start putting money away for my retirement (I don't like to depend on the Government for money!) or as a "just in case something horrible happens" fund :)

I remember learning about compounding in HS, but we never really applied it to anything.

[slowlyfading]

that'a amazing, i never thought of it like that...!

[ProfNot]

Excellent post, Maxter!

Very eye-popping illustration of how compounding works!

THX!

[mcmug17]

I could never imagine a difference in 7 years worth of savings could be this much.

Thanks for sharing!

[ChenChen]

WOW! I need to start contributing more NOW! Thanks for the info, it's really a shock to see it laid out like that.

[Vegas Long Legs]

I'm glad you posted this. Many of the young ladies on here coud really make a difference in their retirement savings if they follow this rule.

[dreamz905]

this really is an interesting chart. i think the point of this chart is to start earlier rather than later and to continue saving each year

[maxter]

Originally Posted by dreamz905

this really is an interesting chart. i think the point of this chart is to start earlier rather than later and to continue saving each year

I just found it so interesting that the end total for saving for 7 years ($14k) at the beginning was nearly equal to saving for 40 years ($80k).

Glad you all found this interesting. I can see what other fun stuff he has and can post that also.

[maxter]

Here's the rest of the article:


Rule 2: DON'T LOSE MONEY: This may sound naive, but believe me it isn't. If you want to be wealthy, you must not lose money, or I should say must not lose BIG money. Absurd rule, silly rule? Maybe, but MOST PEOPLE LOSE MONEY in disastrous investments, gambling, rotten business deals, greed, poor timing. Yes, after almost five decades of investing and talking to investors, I can tell you that most people definitely DO lose money, lose big time -- in the stock market, in options and futures, in real estate, in bad loans, in mindless gambling, and in their own business.

RULE 3: RICH MAN, POOR MAN: In the investment world the wealthy investor has one major advantage over the little guy, the stock market amateur and the neophyte trader. The advantage that the wealthy investor enjoys is that HE DOESN'T NEED THE MARKETS. I can't begin to tell you what a difference that makes, both in one's mental attitude and in the way one actually handles one's money.

The wealthy investor doesn't need the markets, because he already has all the income he needs. He has money coming in via bonds, T-bills, money market funds, stocks and real estate. In other words, the wealthy investor never feels pressured to "make money" in the market.

The wealthy investor tends to be an expert on values. When bonds are cheap and bond yields are irresistibly high, he buys bonds. When stocks are on the bargain table and stock yields are attractive, he buys stocks. When real estate is a great value, he buys real estate. When great art or fine jewelry or gold is on the "give away" table, he buys art or diamonds or gold. In other words, the wealthy investor puts his money where the great values are.

And if no outstanding values are available, the wealthy investors waits. He can afford to wait. He has money coming in daily, weekly, monthly. The wealthy investor knows what he is looking for, and he doesn't mind waiting months or even years for his next investment (they call that patience).

But what about the little guy? This fellow always feels pressured to "make money." And in return he's always pressuring the market to "do something" for him. But sadly, the market isn't interested. When the little guy isn't buying stocks offering 1% or 2% yields, he's off to Las Vegas or Atlantic City trying to beat the house at roulette. Or he's spending 20 bucks a week on lottery tickets, or he's "investing" in some crackpot scheme that his neighbor told him about (in strictest confidence, of course).

And because the little guy is trying to force the market to do something for him, he's a guaranteed loser. The little guy doesn't understand values so he constantly overpays. He doesn't comprehend the power of compounding, and he doesn't understand money. He's never heard the adage, "He who understands interest -- earns it. He who doesn't understand interest -- pays it." The little guy is the typical American, and he's deeply in debt.

The little guy is in hock up to his ears. As a result, he's always sweating -- sweating to make payments on his house, his refrigerator, his car or his lawn mower. He's impatient, and he feels perpetually put upon. He tells himself that he has to make money -- fast. And he dreams of those "big, juicy mega-bucks." In the end, the little guy wastes his money in the market, or he loses his money gambling, or he dribbles it away on senseless schemes. In short, this "money-nerd" spends his life dashing up the financial down-escalator.

But here's the ironic part of it. If, from the beginning, the little guy had adopted a strict policy of never spending more than he made, if he had taken his extra savings and compounded it in intelligent, income-producing securities, then in due time he'd have money coming in daily, weekly, monthly, just like the rich man. The little guy would have become a financial winner, instead of a pathetic loser.

RULE 4: VALUES: The only time the average investor should stray outside the basic compounding system is when a given market offers outstanding value. I judge an investment to be a great value when it offers (a) safety; (b) an attractive return; and (c) a good chance of appreciating in price. At all other times, the compounding route is safer and probably a lot more profitable, at least in the long run.

[boxermom]

Very useful article, Maxter. Without dh's steady hand on his contributions over the years, we'd be sunk now, after United Airlines terminated the pension plans for pilots.

[Bee...Bee]

I am not 'cool' with the way the compounding thing is set up though. I admit that there is compounding effect but it is much less.

If I used 'straight' numbers like this when I was working at an investment bank I would have been fired immediately!

The reason is because $1 next year is worth less than $1 this year so $1 stuck in year 65 is worth way less by the factor of (1/1.05^65-19) than if one assumes interest rate to be 5%. This is not even taking into account inflation which will lower the factor even further!

The article is flawed by the assumption that the interest rate and thus discount rate is 0 and inflation is also 0 making $2,000 in year 65 equal in value to $2,000 in year 19.

Hey don't listen to me, LOL because compounding obviously exists and should be encouraged but its effect is much less!

[maxter]

Originally Posted by Bee...Bee

I am not 'cool' with the way the compounding thing is set up though. I admit that there is compounding effect but it is much less.

I understand what you are saying but I think the article was written years ago when IRA's were first introduced (1980's ?). The total contributable amount of an IRA was set at $2000 for many, many years. (I believe that now it has inched up to $4000.)

I just think that a visual effect really helps people understand the effect of compounding and the importance of saving early. And how saving $14k can be worth nearly the same after 40 years as a $80k investment. Neither one incorporates inflation adjustment so it is not an unfair comparison.

[gloss_gal]

Great article. Thanks!

[Zophie]

Wow. I really need to start my IRA. I'm going to be 35 in three weeks!