For most of us, planning for retirement wasn't a front burner item during our early working years. Consequently, as a financial adviser I often find myself telling people, "It's never too late to start doing the right thing." For young people who are just starting their asset accumulation journey, the most valuable asset they own is time and the most powerful tool at their disposal is compound growth.
Recently, as my 27-year-old physical therapist was getting my shoulder into golfing shape, I asked her about her saving and investing habits. She confessed that she hadn't been putting a big priority on saving and investing yet — no surprise there. So I told her about my fictional friends, Stan and Ollie, 21-year-old twin brothers just beginning their professional careers, and their sister Lucy.
Getting an Early Start
Stan is the prudent brother. He knows that beginning to invest at a young age maximizes his chances of being able to retire at the time and in the lifestyle of his choosing. He starts contributing $5,000 each year to a Roth IRA. After 10 years, his contributions have totaled $50,000. Ollie is a perennial procrastinator and saves nothing during the first decade of his working years. Ollie then has a Prodigal Son moment. He realizes that he has been wasting time and squandering money long enough. So he decides to begin annual $5,000 contributions to a Roth IRA.
After making contributions for 10 years, Stan finds that the expenses of Homeownership and raising a family leave him with no money to invest. So from this point until retirement he makes no further IRA contributions.
Let us assume that both accounts yield a 7% annualized rate of return and that Stan and Ollie work for 45 years. At retirement, which brother will have the larger IRA?
Stan's contributions totaled $50,000, and when he ceased contributing to his Roth IRA it was worth $69,082. Ollie's Roth contributions amounted to $175,000. Upon retirement, Stan's Roth will have grown to $737,000 while Ollie's will be worth $691,000. Intuitively, it seems that this cannot be true.
With a 7% rate of return, an account will double in about 10 years. When Stan stops his contributions, enough years remained for his account to double three times. By the time Ollie has made $50,000 in contributions, he is 25 years from retirement and his IRA has time to double only twice. As we can see from this simple example, compound growth rewards early contributions more than later, more frequent ones.
When growing rich slowly, it's the last doubling that puts you over the top.
Lucy is a college student looking for a summer job. She is offered a position for 30 days of work. Her prospective employer gives her the following salary options:
1) Upon completion of 30 days of satisfactory employment, she will be paid $5 million.
2) She will begin employment with an initial salary of one penny a day and her salary will double each day for 30 days.
Which option should she choose?
By choosing the second option, her total pay for 30 days will be $10,737,418. Even as late as day 21, her daily salary is only $10,485. On day 29 her cumulative salary finally exceeds $5 million. And her pay on day 30 will be $5,368,709. Once again, that last doubling makes a huge difference.
Accumulating retirement assets is a marathon journey during which emotions are your enemy and time is your ally. The wealth created by long term compound growth is available to anyone with the patience, discipline and long-term optimism that it requires. The most successful investors I know have maintained a long-term view and let compounding work its magic.
Wall Street's product pushers know that patience, discipline and long-term optimism aren't easy to sell. So rather than advising you to get rich slowly, Wall Street offers you leveraged funds that promise quick riches by doubling or tripling the market's return. Unfortunately, the hype surrounding these funds has exceeded reality, leading the SEC and Finra to publish a warning that these funds are unsuitable for long-term investors.
I doubt that very many 20-somethings browse the RetireMentors pages of MarketWatch. But perhaps these two examples of the power of compound growth will motivate parents to encourage their 20-somethings to begin investing as early as possible — even if initial contributions are small.
To take full advantage of the benefits of compound growth, investors, especially those just starting out, should own a number of broadly diversified, low cost, tax efficient index funds. By doing so they will maximize their net invested dollars and the long term growth of their portfolio.
Albert Einstein, no slouch when it comes to number crunching, is reported to have said that the most powerful force in the universe is compound interest. And perhaps growing rich slowly is the most unappreciated benefit of patient, disciplined, long-term investing.
This article originally appeared on MarketWatch.com and is reprinted by permission from Marketwatch.com, ©2014 Dow Jones & Co. Inc. All rights reserved.