A friend shared a story with me a conversation he had with his late father. My friend was debating whether to spend money to take a possible trip. His dad responded, “Take the trip – at a certain point, the money takes care of itself.”
Interesting, but true?
Let’s look at this a couple ways.
The Eighth Wonder of the World – The Power of Compounding
Money invested today has a larger value in the future, based upon an assumed rate of growth. Compounding interest is interest calculated on the initial principal and also on the accumulated interest. The mathematical formula is calculated by multiplying the principal amount by one plus the annual interest rate raised to the number of compound periods. (Or, you can locate a compound interest table online.) For example, $1,000 compounding at 10% for seven years is $1,948.72 [$1,000 x (1 + .10) ^7]. As Benjamin Franklin said, “The money that earns, earns money.”
In this example, $1,000 compounding at 10% doubles in seven-plus years. Mathematicians have developed the Rule of 72. They found a shortcut to approximate the length of time needed for money to double.
Years to double = 72 / interest rate
Example: If your money is compounding at 7.2%, it will take ten years to double (72/7.2= 10 years).
Here’s where it gets exciting: at 7.2%, $10,000 becomes $20,000 in 10 years (2x), $10,000 becomes $40,000 in 20 years (4x), $10,000 becomes $80,000 in 30 years (8x), and $10,000 becomes $160,000 in 40 years (16x). Amazing, $10,000 can become 16x larger ($160,000) in 40 years!
A Tree Can Become a Forest in Your Lifetime
In another article, we discussed the need and methods to accumulate a $1 million portfolio of growth investments (cash, bonds, stocks, mutual funds). Again, these are best held in a tax-advantaged account such as an IRA, Roth IRA, or 401k.
Once you create a $1 million portfolio, it takes less time to create the next $1 million. Assuming an annualized return of 7.2% and assuming you aren’t depleting/living off it yet, it takes 10 years to see the $1 million grow to $2 million (need a 100% return – $1 new million/$1 existing million). It takes six years to become $3 million (need a 50% return – $1 new million/$2 existing million). It takes four years to become $4 million (need a 33% return – $1 new million/$3 existing million).
In summary, once a $1 million portfolio is accumulated, it only takes 20 years to become $4 million. The amount of time it takes you to accumulate a second and possibly third million may be shorter if you are still working and continuing to fuel (via saving) the economic engine you have created.
As you can see, my friend’s father is definitely correct! At a certain point, the money easily takes care of itself. Once you’ve created it, it takes fewer years to replicate it.
How Compound Interest Worked for My Friend
The friend I reference shared a portion of his personal investing story with me. He started his working career 35 years ago. After graduating from college, his starting salary was about $20,000. He worked for his first employer almost 14 years. During his career there, he invested slightly less than $4,000 per year into the company’s 401K (approximately $54,000). After leaving, he could no longer invest in their 401K. However, he kept his investment in this employer’s plan, as he liked the investment options. Today, 20 years later, the value of this 401K alone, now exceeds 12 times his original investment (approximately $650,000). Of this value, the match the employer provided currently represents 28% of the total value of the 401k (approximately $180,000 — more than 3x his personal cumulative investment). While in his early years he invested too conservatively — a mistake made by many who don’t invest enough in stock mutual funds — he corrected that early mistake, and has left his 401k 100% invested
in domestic stock mutual funds ever since.
I’m sharing this story for several reasons:
1) Money can compound at a fast pace – allow acorns to become a tree and trees to become a forest.
2) There is real value in taking advantage of your employer’s full 401K match.
3) It doesn’t require a huge annual savings to create wealth, especially if you start early.