Do you hate math?
If you do, I’m convinced you’re going to love it by the time you’re done reading this post.
Why? Because of the magic of compound interest.
Albert Einstein once reportedly called compound interest “mankind’s greatest invention.” While Snopes might dispute whether Einstein was truly the source of this claim, there is no arguing that compound interest is an incredible mathematical beauty.
The idea behind compound interest if fairly simple, and it goes like this: Let’s say you invest $1000 in the stock market, and the stock market gives you a return of 10% annually. After one year, you will have $1100. You’ve made $100. Now, if you leave that $1100 in the stock market, you don’t just earn 10% interest on the original $1000, but also on the $100 you earned over the last year. You’re earning 10% on the entire $1100. After your second year, you will have $1210 ($1100 + 110). After year three, you’ll have $1331.
At first, this doesn’t sound like much. And it isn’t. But if you leave this snowball rolling, the numbers start getting exciting. After 10 years, your money will have turned into $2593,74. After 30 years, that little $1000 becomes $17,449.40.
You know what else is crazy about these numbers? 10% isn’t too far off what you might expect to make on average each year by investing in mutual funds (more on those in my next post). More conservative financial advisors might argue that you should only plan on 8%, but anywhere between 8% and 10% isn’t unreasonable, historically.
At my age of 22, if I assume I retire at the typical retirement age of 65, every dollar now could be worth over $60 in retirement.
Ever since looking at these numbers a couple of years ago, I have started to think of money in terms of its potential value. Sometimes, if I’m thinking of buying a Frappucino from Starbucks, I’ll stop and think, “Would I rather spend $5 on this Frappucino or have $150-$300 in retirement? A $50 meal at a restaurant could be worth $1300-$3000. Spending $3000 more on a car than necessary could cost $80,000 to $180,000 in potential dollars.
Of course, I don’t always think in this way or I would never be able to enjoy my purchases. I love taking my wife out on dinner dates, going to movies occasionally, and otherwise enjoying life. Nobody wants to go through their entire life as a complete miser for the sake of retiring with money. However, I have found this method of potential-cost analysis to be helpful in talking myself out of spending money on things that won’t really contribute value to my life.
Dave Ramsey uses a particularly compelling example of two young guys, Ben and Arthur. Ben, at age 19, starts investing a couple thousand dollars per year until he’s 26 years old, and then stops. After 26, he never contributes another dollar. Arthur decides at 27-year-old that he should probably start putting some money away. He starts investing the same $2000 per year, but does so until he’s 65. In the end, even though Ben only saved for 7 years and Arthur saved for 38 years, Ben still came out ahead with almost $2.3 million compared to Arthur’s $1.5 million. The message is clear: start now!
When I graduated and started my new job at the beginning of this year, I started putting 15% of my income into retirement. It’s thoroughly satisfying to watch the numbers climb and to realize that all of those dollars are going to grow exponentially over time. One day, at least a couple of decades from now, we’re going to hit a crossover point where the interest generated from these investments creates more money every year than we do by working for an income. That’s where compound interest really starts getting exciting!
Have I succeeded in making math your friend for once in your life? If so, let me know in the comments below.
Do you currently invest money for retirement? If not, feel free to share your thoughts about what’s holding you back!