Real Power of Compound Returns

Want to become a millionaire?

Unless you are counting on that big inheritance or playing the lottery every week, your best shot is through investing.

Keys to Compound Return Benefits

The key is to start when you are young. The amount that you invest is somewhat less important than the time frame. If you are not young, start now. You can still benefit from compounding, though to a lesser extent.

Prudently invest on a consistent basis and let the power of compounding do its thing. We will examine what might constitute “prudent” investing in due course.

Utilize tax-free or tax-deferred investment accounts to enhance compounding impact. Look to low-cost investment products to reduce fees and expenses. You want your money to compound on your behalf. Not to enrich the government, investment company, or your friendly financial advisor.

For more detail on these points, please review, “Compound Returns” and “Compound Return Investment Lessons”.

Compound Returns in Real Life

Please consider the story of Nicole and Matt. Not quite an Aesop Fable, but good moral lessons contained within.

The Ant

Nicole is turning 25 years old, has just started a new job, and wants to begin saving for her retirement. She decides to save $300 per month in a tax-deferred retirement account.

Based on historic returns, she expects to earn a net 8% per year in a family of no-load diversified mutual funds that reinvest any income earned back into the funds. We will assume that income compounds semi-annually.

Following this strategy, by age 40, Nicole will have invested $54,000 in total. However her asset value will be worth $104,504 due to the 8% net annual return and compound growth.

If Nicole is wise, she will increase her monthly contributions over time as her salary increases. She will also continue investing until the day she retires.

But at age 40, Nicole decides to set up a separate investment account with her husband and no longer contributes to her first plan. Nicole does not liquidate her initial retirement plan so that $104,504 will continue to grow at 8%.

At age 70, Nicole terminates her individual plan. She is surprised to discover her asset balance has grown to $1.09 million.

For a relatively brief commitment of 15 years and $54,000, she became a millionaire. Not too bad.

And the Grasshopper

Matt is Nicole’s twin brother. Matt has a well-paying job but he always seems to spend as much as he earns. At month end there is nothing left to save, although he does have a nice tan from his recent vacation to Hawaii.

As he turns 40, he notices that Nicole has done quite well from her monthly saving plan. Wanting to copy her success, Matt visits a financial planner.

Matt knows that Nicole has stopped saving. With 30 years to invest, twice the time frame as Nicole had, Matt figures that it will be simple to catch up with her. Maybe he can even do so with less than $300 per month. That would be great.

Matt instructs the financial planner to create an identical investment strategy as Nicole. That is, the same diversified portfolio of low-cost mutual funds netting an 8% annual return with income semi-annually compounding.

Unfortunately, Matt does not understand the concept of compound returns. So he receives quite the shock when he gets the financial planner’s program.

To catch Nicole at 70, Matt must invest $750 monthly for 30 years in an account earning 8%, compounded semi-annually.

Nicole invested $54,000 over a 15 year period.

To match her accumulated $1.09 million in wealth, Matt must contribute $270,000 of his own money over 30 years.

Matt must find more than double the cash that Nicole invested each month and he must do so for twice the time frame. In total, Matt must pull five times the cash out of his own pocket to achieve the same result as his sister.

A lot more sacrifice for Matt to amass the same wealth as Nicole. Smart lady.

Moral of the Story

That is the power of compounding.

Start investing as young as you can. The longer the time frame the better.

The sooner you begin, the less you actually need to invest in total contributions.

Even relatively small investments can grow to large amounts over a long time period.

Return is crucial. Gross returns on the investment itself. But equally so the net returns after fees, costs, and taxes.

Had Matt been able to net 9% annually, rather than 8%, he could achieve almost the same total investing only $600 monthly. If his return was only 7%, he would need to make monthly contributions of $900.

At the 8% return, Matt’s monthly contribution of $750 for 30 years grew to $1.096 million. Now let us say that the mutual fund company he chooses charges a 1.0% annual management fee on the funds. Not a lot as far as most charge. And really, what is 1.0% among friends?

However, that reduces his net return to 7% and his assets only grow to $902,000. A decrease of $194,000 in wealth.

A percentage of return paid to a fund company, bank, or advisor annually, has enormous long term ramifications your wealth. Finance your own retirement, not someone else’s.