Compound growth (or losses!) can be confusing. When it comes to compounding, using quick mental arithmetic to make investing decisions can be detrimental to our financial health. If we don’t take the time to understand the power of compound growth, to feel its power, we might not even find the motivation to start saving & investing. That might prove to be a costly oversight down the road. And it’s very difficult to compensate for those lost years later. Life really is too short.
Try this little brain teaser …
If someone offered you a penny to work all day, would you do it?
What if they asked you to work for a full month but, this time, they offered you a penny for the first day of the month & then promised to double the previous day’s pay for you, every day, ’til the end of the month?
If you think this is a trick question, you’re right. But without grabbing a calculator, how much to you think you’d be owed at the end of the month? Take a stab at picking a number now & I’ll share the calculations further down.
Ever since Jack Bogle gave us the low-cost index fund, there has been widespread support for retail investors, particularly younger investors with a long time horizon, to follow that path. Even the inimitable Mr. Buffett recommends low-cost, index-tracking funds for most of us. After taking fees into account, there aren’t too many actively managed funds that can beat the market index over time. The market has grown by about 10% annually for a century or more. If it works like that going forward, a kid saving $100 a week from age 20 to 65 might have a portfolio worth almost four million dollars by retirement. That’s the power of compounding. If the kid invests in an equivalent high-fee fund that reduces that annual growth rate to 8%, the portfolio would be worth a little over two million come retirement day. That’s the power of compounding in reverse! Fees of “only” 2% eliminated almost 50% of the end value. Fees compound too. Just not in favour of the investor.
The magic of compound growth is tough to visualize with any degree of accuracy. I need a tool or a calculator to compare investing returns over time. Particularly when it comes to comparing a growth investment against one that pays a dividend that gets reinvested. While past performance may not be replicated going forward, historical performance can make for some interesting comparisons. And those real comparisons will probably be very different to guesstimates based on my mental arithmetic. Our heads don’t do compounding well. But compounding might do well for us. If we allow it enough time to work it’s magic. Play with a compound growth calculator. It might encourage you to get started. Once you understand the power of compounding, you should be motivated to get started right away. Compounding takes time & patience. But you’ll never truly get to appreciate its value if you don’t start early enough.
What if you’re old already? I know that story all too well. Each investor has a different risk tolerance, level of knowledge, savings rate, & so on. Even two investors with very similar investor profiles may invest in very different portfolios. Compounding doesn’t care. It will do whatever it can with our investments, with whatever time is available. Based on your investing style, plug in the numbers for your timeline, with your expected rate of return. See if the possible outcomes are close to where you’d like to be by retirement day. If not, you might need to save more, sooner, to get there. Or maybe you’ll see that financial freedom is not too far away for you. A compound growth app might be one of the best games to have on a mobile device!
Does your head do compounding well? What number did you come up with from the opening question?
At the end of the first week, you’d be due about a buck & a quarter. Not even enough for a cup of coffee these days. Pretty awful, eh! By the end of the 2nd week, that would jump to $164. Hardly earth shattering. The 3rd week, however, would be almost $21k. Yes, twenty one thousand dollars. Things are improving now. At the end of the 4th week, the number would be almost $2.7 million. And only three days later, at the end of the 31st day, it would be almost $21.5 million.
The total wages due on that penny starter wage, by the end of the 31st day of the month, would be almost twenty one & a half million dollars. Now, that’s some kind of compounding!
How close was your guess!?!
I like the calculator at the Ontario Securities Commission website here. The graph of results here shows a great image of how the power of compounding works better over time. Go play!
Important – this is not investing advice, it is for entertainment & educational purposes only. Do your own due diligence & seek professional advice before investing your money.