December 23, 2013

The Powerful Effects of Compounding

Compounding is like a snowball. As the snowball rolls down the hill, it gets bigger and bigger with each revolution as it picks up more and more snow.

Buy and Hold investing is similar to a snowball. The dividends and capital gains you receive each year, if re-invested, generate even more earnings in the following years. You receive earnings not only on your original investments, but also on any interest, dividends, and capital gains that accumulate. Each year’s potential earnings on your investment can contribute a little more to earnings the following year.

As time passes, earnings can contribute more and more to the total value of an investment to the point that it may be generating your annual salary's worth income. If and when this happens, you can consider yourself financially independent at that point.

BUT, the problem is that many people DO NOT get to this place when they retire. It is really a sad scenario because achieving financial independence is within everybody's reach if they understand the powerful effects of compounding.

I see people complaining of their inability save, yet they have all of the latest electronics and expensive lifestyles. In my opinion, most people need to evaluate what they are spending and reduce the wasteful expenditures. Once wasteful expenditures are under control, they can put that money to compound over a long-period of time.

Here is a powerful example why compounding matters.

Let's assume you invest $10,000 in a mutual fund that earns 8% annually and leave this investment for 20 years to compound. At the end of the 20 year period, it will grow to $46,609.

If you increase your investment horizon to 30 years, your investment will grow to $100,626.

Instead of just letting your initial investment to compound, what if you added $100 each year to it and let it grow. After 30 years, it will grow to $236,566.

If you added $500 each month ($6000 yearly), your nest egg will grow to $780,325. It is really not that hard to save $500 per month.

How about saving $1000 per month ($12,000 per year). It will make you a millionaire in 30 years.

If you stretch your savings rate to $1500 per month (effectively $18,000 per year), roughly maxing out your 401(K) plan each year, your nest egg will grow to over $2 million in 30 years.

And if you've got an even longer time frame—for example, if you're in your 20s and saving for retirement—after 40 years, your investment will have grown by more than $4.8 millions.

Is it really hard to save $1500 per month for your own retirement security?

The answer is actually NO.

Let's say you make median household income in the US of about $52000 per year. If you are married and file jointly, you fall into 15% tax bracket. Let's say your state has a 6% tax bracket. You owe about $11,000 in federal and state taxes. This leaves you about $41,000 in take home pay.

If you invest $18,000 towards your retirement, then that leaves about $23,000 towards your household expenses. To make a rounding number, let's say $24,000, about $2000 per month.

If you bought a $200K home (which is actually on a higher side), your monthly payment on 30 year loan @4.5% interest rates will be about $800. That leaves you about $1200 for utilities, food, transportation, and everything else. Can you manage your household with $1200? The answer is absolutely YES.

If you sacrifice on your lattes, expensive cell phones, cable bills and manage your household budget like a business, it is NOT impossible.

Saving Early: If you start saving early (I mean really early) as soon as you start your first job in 20's, you will have lots of time for your compounding to take effect. When you are single, not married, and without kids, it becomes very easy to save early. Once you get married and have children, it gets a little harder. So, the sooner you start, the less money you will be required to save later on when your priorities shift towards the family.

Bottom Line: For compounding to work, you need to: Sacrifice short-term instant gratification for long-term retirement security. Start investing now. Invest regularly. Be patient.

1 comment:

  1. Excellent blog right here! And Merry Christmas!