When my stepdaughter Rachel reached middle school, she began to hate math. One night, when she was struggling with her homework, she exclaimed, “Math is useless! Why do we have to learn this stuff?” I asked her not to give up because although she might not realize it now, math has many practical applications, especially when it comes to building wealth.
Since 13-year-old Rachel loved baking, one day I gave her a mathematical challenge. Since we only had two-thirds of the flour called for in the recipe for a chocolate molten lava cake, I asked her to calculate how much of the other ingredients would be required. She was so excited to eat cake that she figured out how to multiply all the ingredients by two-thirds in her head! Later, as we were biting into delicious pieces of chocolate heaven, I asked her, “So, do you still think math is useless?”
Girls who don’t appreciate math while they’re in school sometimes grow up to be women with dangerously little knowledge about personal finance and investing. But if you can follow a recipe to bake a cake, you certainly can follow a recipe for building wealth.
To build a “cake of wealth” you need only three ingredients: principal, rate of return and time. For example, if you were investing your money in a savings account, your principal would be the money you initially put in the account, the rate of return would be the annual interest rate the bank pays you, and time would be the period between when you invested the money and when you took it out.
If you deposited $1,000 in a savings account that paid 2 percent interest per year, and you held it for one year, your money would then be worth $1,020. What happens if you keep the money invested for many years? In that case it benefits from compound interest, which is like the secret ingredient you add to your cake batter that makes it even more delicious! When compound interest is applied, the money you earn from interest is added to your principal and you get paid interest on your interest.
Even if you start investing with very little principal, if you add to the batter a good rate of return and keep stirring it for a long time, out of the oven will come a big cake of wealth.
For example, if I invest $1,000 over 20 years at a 10 percent annual rate of return, I end up with much more than double the money I would have if I invested at a 5 percent rate of return. But there is no such thing as a free lunch. The only way to get a high rate of return is to take risk, typically by investing in the stock market or real estate. Women who are afraid of risk tend to keep their money in a savings account or certificate of deposit. Interest rates have been at historically low levels for several years so “savers” are not building their wealth. In fact, due to the rate of inflation, they are actually losing money every year. In my previous example I used a 2 percent interest rate for a savings account, but good luck finding a bank that currently pays even close to that.
Time, the third ingredient in the wealth-building recipe, is like butter in a traditional cake recipe. It creates a creamy texture — sort of like a cushion — that dampens the volatility of the stock market or real estate. While Rachel was baking at 13, imagine if she was beginning to invest! Think of what she’d have down the road.
Investing doesn’t have to be scary or complicated. Although you can lose money when the stock market goes down, if you have time on your side, you too can build a cake of wealth. And it’s a lot fewer calories and more delicious than a regular cake.
Part of this article and the graph was excerpted from Every Woman Should Know Her Options: Invest Your Way to Financial Empowerment.
Laurie Itkin is a member of the DailyWorth Connect program. Read more about the program here.