I have a question for you. Would you rather have $100,000 cash or a single penny that doubles every day for 30 days in a row?
Think about it.
Think a little more about it.
Now, which would you choose?
If you’re like most people, you would have taken the $100,000. And you would have been wrong. Very wrong, in fact. Because you’re thinking linearly, not exponentially.
The Power Of Exponential Growth
Let me show you what I mean:
That $100,000 sounded pretty good at first but it was ultimately no match for the exponential growth of compounding interest. You see, $100,000 is still $100,000 at the end of 30 days. It may have been hard to imagine at first, but $.01 doubling every day would grow to over $5 Million. This is the power of compounding interest.
What’s especially interesting to me in the chart is that even on Day 15, halfway through the month, you’d only have $163.84 if you took the penny- not much. And it’s not until Day 25 that you cross the $100,000 mark. But then in the last 5 days the original penny would grow by more than $5.2 million and in the last day alone by more than $2.6 million!
Surprised by the results? It’s no wonder that Albert Einstein, perhaps the greatest mind that ever existed, called compounding interest the eighth wonder of the world.
How Compounding Interest Affects Your Retirement Savings
Now let’s apply this to real life and talk about your retirement. I believe that compounding interest are the two most important words regarding retirement savings. Why? Your retirement grows exponentially, not linearly. Great news, isn’t it?
Reinvesting the gains within your retirement funds means more rapid growth over time. Benjamin Franklin described it this way, “The money that makes money, makes more money.” Your money earns interest, which then earns more interest, and so it continues. The magic ingredient is time. That means the key is to start as early as possible.
How Time Impacts Compounding Interest
Look at the chart above again, only this time translate the ‘days’ into ‘years’. Think of your retirement as a 30-year journey of saving prudently and patiently. At day 15, halfway through, you may still be questioning why you took the exponential path. About three-quarters of the way through, however, things start to change.
Now let’s be clear -- money rarely doubles like it does in this analogy, but nobody is offering you $100,000, either. Luckily, it doesn’t need to double. The S&P 500 has, on average, returned annual gains of about 10% over its nearly 100-year history. This is plenty of growth to fuel a healthy retirement, thanks to compounding interest. That is, as long as there is enough time for the interest to compound exponentially.
To demonstrate, below is a comparison of three families that each contributes $10,000 per year to their retirement fund. The funds are not invested entirely into the stock market, but rather into a mix of stocks, bonds, and other funds relative to the families’ risk aversion. For simplicity, this example assumes 7% returns each year for all three families. The only difference is the age at which they begin investing: 25, 35, and 45.
Similar to the doubling penny example, it's incredible that the family that started saving at age 25 has only $686,765 saved after the first 25 years of saving, but then in the final five years, from 60-65, their account grows by more than $656,000. Yes, you read that correctly - the family that starts saving at 25 years old sees their account grow by nearly the same amount in the last 5 years as the first 25 years, even though they're only contributing $10,000 each year! The two that started later missed out on these crucial years of rapid growth prior to turning the typical retirement age of 65.
What Does This Mean For You?
If you haven’t started saving yet, don’t panic or live in regret. Do the one thing you can control, and that’s to start saving now! Put as much as you can towards your retirement now and make a goal to continually and regularly increase your contributions. Regardless of the age you start saving, you will still be better off than if you didn’t save anything at all.
If you’re already investing regularly, don’t get discouraged because you don’t see a lot of progress being made. Just be patient and trust that your money is already at work. Look at the last few rows of the two charts and remind yourself that diligence and discipline now will reap big results later.
Looking for more guidance on how to put these principles into practice and take advantage of the incredible power of compounding interest? Reach out to me today for a free 30-minute consultation!
About Wacek Financial Planning
Founder Ben Wacek is a fee-only Certified Financial PlannerTM and Certified Kingdom Advisor® who has a passion to help people of all income levels make wise financial decisions and steward their resources from an eternal perspective using Biblical principles. Based in Minneapolis, MN, he works with clients both locally and virtually throughout the country and abroad. If you’d like to learn more about Wacek Financial Planning, please visit www.wacekfp.com.
Photo by Jeff Weese from Pixaby.