Compounding Your Way to Wealth: The True Power of Saving Early in Life

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Investing 101

“Time is money.” How often have you heard that? The funny thing about investing is that the correlation of time and money is absolutely true. There’s even a nifty calculation in finance theory that proves it, called, naturally, the “time value of money.”

You run into this calculation all the time, probably without realizing it. The interest rate on a credit card, for instance, is a calculation of interest earned if you delay repayment. If you have ever taken a car loan or a mortgage, you probably saw a very long series of number columns (especially if you signed a mortgage), known as the amortization table. It shows, month by month (time), the payment amount, broken down into how much is principal and how much is interest (money).

When you invest, you are doing exactly the same thing a credit card company or bank does: Lend money out for a period of time at an expected rate of interest. How much money for how much time is your time value of money.

That’s the easy part. What few people realize is just how very large the time factor is when it comes to saving and investing. Simply put, a small amount of money put away from a long period of time can turn into quite a large sum.

Abigail vs. Tim: The Savings Challenge

How much? Well, consider this example. Abigail is just out of college at 22. She manages to graduate debt-free (yippee!) and gets an entry-level job in sales. Money is tight, but she decides to start saving $400 a month into a savings account that pays 1.5% (wishful thinking at today’s rates, but stay with it).

Eight years on, Abigail reaches 30. Her savings account balance, including interest, is $41,273 and change. Nice, right?

Okay, so here’s where things get interesting. She dumps that balance into an investment account and earns an average of 10% annually for the next 35 years. At 65 years of age, the balance is well over $1.1 million — yet from 30 to retirement age she does not put in even one more dime! Her gains come from compounding alone.

Tim is her classmate. He puts off saving all through his 20s. He buys a nice new car, enjoys a skiing vacation each year, eats out whenever he likes, perhaps five nights a week if he’s busy at work. He gets to 30 with virtually no savings. Can he get to $1 million by 65?

Running Behind

He can still get to the goal, but he’s lost those first eight years to spending. Tim has to put away $325 a month without fail for the next 35 years to come up with a balance comparable to Abigail’s. No matter what happens financially, Tim is strapped into permanent saving to make up those lost eight years, while Abigail can save more (or not) over the ensuring decades and still end up a millionaire. (If she stays with her $400 plan over those decades, her total is nearly $2.6 million.)

How can you make this simple trick work for you? One way is to immediately join your company’s 401(k) plan. Your employer should be able to auto-deduct from your check. Painless savings. You won’t even miss it.

If you don’t have a 401(k), open an IRA at your bank and set up automatic deductions from your checking account. The really important step is to remove the obstacle of “thinking about saving” and turn it into repetitive, automated action, ASAP.

Investing On Autopilot

You can save straight into a standard, taxable investment account, of course, but you lose the tax advantages of an IRA or 401(k), and you are more likely to liquidate it in a panic if the market temporarily slides. That’s because retirement accounts carry tax penalties which make removing the money crazy painful. That alone tends to keep you in the market long-term, rather than jumping in and out willy-nilly.

Likewise, automated savings plans allow you to make automated investments, putting in the same amounts like clockwork over many months and years. The advantage of that approach is that you end up dollar-cost averaging, that is, buying more shares when stocks are cheap and fewer when stocks are relatively pricey.

It’s counterintuitive, but research shows that such programmatic investing nets you more over the long-term by removing the itchy trigger finger from your accounts. Instead of chasing performance and missing it, you build a market position slowly but surely.

Do you need to calculate all this out to the penny to get started? Of course not. Pick a monthly savings amount that you feel is aggressive enough, set it, and forget it for a while. You will have worse problems in life than deciding how best to invest your growing cash cushion. Remember the guy that said “time is money?” He also said “a penny saved is a penny earned.”

 

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