If there is one investment tip or lesson that you could take away from me in this blog, my BNN interviews (sorry Garth), our weekly calls, and other media events, the earlier you start investing the richer you’re going to be in the future due to the power of compounding returns.
Some of the smartest minds and most successful investors to ever live understand this important mathematical concept. Warren Buffett has said, “Compound interest is an investor’s best friend.” Albert Einstein once said, “Compound interest is the eighth wonder of the world.” If it’s coming from these fellas, we should be heeding their advice!
Let’s start with the basics. What is compounding and how does it work?
Say you invest $100,000 and earn a 6% long-term return. At the beginning of year 2 you would have $106,000. In the third year you would have $112,360 or $12,360 in profit. In year four $119,102 or $19,102 in profit. The profits are compounding, which is earning interest on interest. And the key is to start that process as early as possible to get the most out of compounding.
Here’s an interesting story to help hit this home.
Warren Buffett, arguably one of the greatest investors to ever live, started investing at the ripe old age of 11 and by age 30 he made his first million. Today his net worth is over $100 billion and is the fifth wealthiest person in the world. Yes, the 20% long-term return (double the S&P 500) earned by his company, Berkshire Hathaway, had a huge impact on his success and net worth today. But the real secret behind his success is that he started investing at an early age, allowing for the magic of compounding to really take hold.
From the age of 30, when Buffett made his first million, by the time he turned 50 he had amassed a net worth of $376 million. At age 70 he was worth $36 billion, and today he’s now over $100 billion. In fact, 99% of Warren Buffett’s net worth was earned after his 50th birthday. His net worth has ‘hockey-sticked’ over the last 20 years due to all the hard work of saving and investing from a young age.
Let’s look at a few more examples.
If you invest $10,000 per year for 20 years at a 6% return, the portfolio will grow to $367,855. That works out to $200,000 in total investments and gains of $167,855. However, if you invest $10,000 per year for 40 years at the 6% the portfolio would grow to $1,547,619, which equates to $400,000 in savings and total gains of $1,147,619. So, the difference of $200,000 in additional investments translates into a difference of a million dollars in your final portfolio by starting earlier.
Here’s another way to look at it.
Deanna started investing $5,000/year at the age of 25 and does this for 10 years. At age 35 she stops investing and just lets the portfolio grow and compound until her retirement at age 65. Her spendthrift husband Brett was busy buying beers and Harley’s, so he starts saving the same $5,000/year but at age 35. He does this to the age of 65 (30 years total) and they both earn the same return of 8%.
In total Deanna saved $50,000 while Brett saved $150,000. At age 65 Deanna’s portfolio is worth $787,176 and Brett’s at $611,729. Deanna invested far less than Brett but because she started earlier, she wins in the end because she was smart enough to start investing early, taking advantage of the power of compounding.
So, today’s public service announcement is don’t be Brett! Be like Deanna, start saving early and let compounding do its work. Now get going!