Three Key Takeaways:
- The power of compounding is one of the most effective ways to build wealth
- Small investments can turn into massive gains over time
- $5 saved a day, at 10% annual return, will leave you with $1.36 mil in 45 years
This is part 1 of a 3 part article written to demonstrate the incredible power of compound interest, the ability of the stock market to access that power, and how to determine if the stock market is better than home ownership. The ideas herein are complemented with an accompanying dashboard that can be used to enter in assumptions relevant to your situation. Technical people can find my source code on GitHub. Enjoy!
Opportunity Cost
In Economics, one of the first things taught is Opportunity Cost. This represents what you are giving up with any decision. For example, when you buy a car for $10,000, the opportunity cost is all the things you could otherwise buy with the $10,000. When you go for a walk, the opportunity cost is the other things you could have done with that time. Every decision comes with opportunity cost and this dashboard helps you quantify the costs of financial decisions over time. The ideas discussed below are certainly nothing new, in fact it has even generated its own term known as “coffee shaming”. While I have no intent on shaming anyone for the decisions they make, hopefully this tool can demonstrate the incredible power small changes can make overtime. Perhaps you can find one or two small expenses that can be invested instead.
Coffee is a perfect example. A cup of coffee typically costs $5. To immediately assume $5 opportunity cost is not entirely correct. What if you invested that $5 into the stock market? Depending on your age and daily coffee intake, that daily coffee could cost you over $1,000,000 in your lifetime! Figure 1 below demonstrates this fact.
Figure 1: The opportunity cost of a $5 daily cup of coffee
The Power of Compounding
How is this possible? As Albert Einstein said “Compound interest is the most powerful force in the universe”! When given enough time, the power of compounding can have profound effects. Assuming a cup of coffee costs $5 and you average one cup every day for 45 years (very plausible for a 20 year old), the $81,000 you spent on coffee could have become $1,357,882 assuming a 10% return! If you notice, the first 10 years show very little growth and returns only $12,000 on the investment of $18,000. But as time ticks on, and the base investment of $5 a day keeps compounding, your money begins to grow exponentially. There is a great article on the rule of 72 that discusses the time it takes for an investment to double.
Okay, maybe you really love that morning coffee. It’s a good reason to step away from your desk, increase your focus, and make you more productive. That’s fine, but is there some daily, weekly, or monthly cost that you could invest instead of spend? Using the dashboard linked to above, plug in some of your discretionary spending items and see the incredible impact of compounding. If someone could manage to save even just $1 a day. Their return on investment (ROI) could be $255k assuming a 10% rate of growth:
I’m in no way trying to guilt or shame anyone into giving up something they enjoy or appreciate. If you want to pay extra for guacamole, then do it. Keep your coffee habit if it makes you happy. This tool is simply trying to demonstrate the true opportunity cost of those habits so they can be evaluated properly. Is there a monthly membership that you don’t really use (I know people who paid for AOL into the 2010s!).
The power of 1%?
One important caveat is the massive impact of small changes in percentage points. The chart above clearly demonstrates the importance of time, but what about the difference between 8%, 9%, 12%, or 15%. The table below shows the differences between these seemingly small changes in compounding. As can be seen in Figure 2 below, the differences are not linear, but exponential! This still assumes saving $5 a day and starting with $0. The difference between 10% and 12% is more than $1mil. The difference between 8% and 10% is nearly $600k!
Figure 2: $5 a day invested at different rates
To really demonstrate the impact of percentage rates over time, consider Figure 3 below. The current IRA contribution limit is $6,000 (In a future article I will discuss why you should always contribute to Roth instead of Traditional). For someone graduating from college planning to retire in 45 years, an annual $6,000 contribution will result in $4.7M assuming a 10% rate of return. When that return drops to 9%, the ending balance is $3.4M.. A change in 1% had a $1.4M impact on a $6,000 annual contribution. That is the exponential power of compounding! Put another way, a 10% decrease in return (10% to 9%) resulted in a 30% decrease in your ending balance.
Figure 3: $0 starting balance, $6,000 added a year
What about someone who is fortunate enough to max our both IRA and 401k (19,500 limit) saving a full $25,500 plus a 3% employer match of 28,500 (3k assuming 100k salary). The change from 9% to 10% by year 45 is more than $6,000,000 ($22.5M vs $16.3M)! Never mind the most likely unattainable 12% annual growth that pretty much doubles the $22.5M to $43.5M! See results in Table 2 below.
Figure 4: $0 starting balance, saving $28,500 a year
Why highlight the effect of 1% change on returns? 1% is typically the minimum you will pay for financial advice. Should you get a financial advisor? Maybe, but you should absolutely understand the cost. The S&P 500 has averaged 10% per year since 1988, a financial advisor will usually cost you at least 1% a year. For a 30-year old maxing out their IRA each year with 6,000, the financial advisor will cost you ~$375K during a 35 year period (1.4m vs 1.78m)! This does not necessarily mean a financial advisor is not worth it, especially if they get and keep you in the stock market, but you should know the impact over time! Keep in mind, the financial advisor is not earning 375k. By taking 1% a year. Instead, they are removing the ability for your investments to compound.
Wrapping up: time and rate of return
We discussed the importance of two critical variables in compounding, time and rate of return. Unfortunately, the time you have remaining is currently out of your control, unless you believe several futurists who think we are in the process of conquering time with escape velocity. If we are, then imagine the power of compounding over 100 years - or let’s not imagine… a 6,000 annual contribution compounding at 10% would land you with over $1 billion! But until this science solidifies, time is out of your control. Instead focus on maximizing your annual rate of return which could be 7-10% for prudent and disciplined investors (investors who develop a strategy and stick with it!).
So how can you access 7-10% annual returns? While nothing is certain, history shows that the stock market has been an excellent mechanism to achieve decent returns over time. This is the topic of discussion in part 2.
Disclosure: The content herein is my own opinion and
should not be considered financial advice or recommendations.