April 6, 2012

Investing 101: A Magic Concept That Grows Money

Father and son surf lesson in Morro Bay, CA - image by Michael "Mike" L. Baird
Due to some unforeseen circumstances at my day job, I did not have time to write a post for today.  Instead, I decided to dig out my 2nd ever post on this blog, re-work it and re-post it.  Since this blog only got about 2 page views per day back then, most of you have probably not read this.  I re-titled it, did some light editing and added a non-relevant picture.  I feel very strongly on this topic and thought it was absolutely worth posting again.

The following concept is very easy to comprehend.  This is one of the most important life lessons that should be taught to everybody concerning finance, money, or investing.  In fact, I feel so strongly about this that I think it should be mandatory that everybody learn this.  Ideally, this would be required learning for every single student before they graduate from high school.  


What I am talking about is a concept called, compound interest.  This is a simple formula that anybody can understand and utilize.  This post is a must read for every beginner investor who wishes to retire a millionaire.  It is especially important that everybody age 18-22 understand this strategy.

First, I want to show you the technical definition and formula for compound interest.  This is for math geeks only!  If you are not a math geek, please ignore this and skip down to the dummies section.  There, I will explain the concept visually and in terms that are easy to understand.

Compound Interest Defined
Interest which is calculated not only on the initial principal but also the accumulated interest of prior periods. Compound interest differs from simple interest in that simple interest is calculated solely as a percentage of the principal sum.

The equation for compound interest is: P = C(1+ r/n)nt

Where:
P = future value
C = initial deposit
r = interest rate (expressed as a fraction: eg. 0.06 for 6%)
n = # of times per year interest is compounded
t = number of years invested

Compound Interest for Dummies
I first learned about this concept when I read a book called, Financial Peace, written by Dave Ramsey.  Luckily, I was still in my early 20’s when I discovered how the power of compound interest could work to my advantage.  Let me explain why this timing was very important.

Compound interest is interest on an investment that compounds, or grows over time.  Not only is interest gained on the original investment amount, but also on the interest amount that has been added.  For example, if you invest $100 and expect a 10% annual return, your investment will gain $10 the first year.  Your investment is now worth $110.  The next year, that same 10% return will yield an $11 return to make your investment now worth $121.

Using the original $100 investment, if you gained only $10 per year, your investment would be worth $200 after 10 years.  Using the compound interest method, your investment would be worth $259 after 10 years.  Try adding a few zero’s to these numbers and we are starting to talk about some serious money!  This may not sound like a big deal, but wait until you see what happens when you start adding more years to the equation.  The numbers start to multiply exponentially!  This is why timing is so very important.  The more time your money is invested the more time it has to take advantage of the power of compound interest.

The Ben & Arthur Example
If you still don’t quite grasp this concept, you will after you see this.  Of everything I learned in Dave Ramsey’s first book, Financial Peace, this is by far the one lesson that has had the most impact on me.  I saw the Ben & Arthur example in the book and couldn’t believe it.  It is mind boggling the way the numbers work.  Here it is, with some fictional but very probable life situation examples added by me.

Let’s say Ben & Arthur graduate high school at the same time.  Ben decides to enter the workforce right away, while Arthur opts for the college route.  After one year on the job, Ben is eligible to start contributing to his company 401k.  At age 19 he starts investing $2,000 per year, but then stops at age 26.  Arthur gets his 4-year college degree and then spends the next 4 years paying off his student loans.  Finally, at age 27 he is ready to start investing.  Arthur invests $2,000 per year, every single year until retirement at age 65.  Guess who comes out ahead at age 65!

Assuming an average annual return of 12%, Ben ends up with $2,288,996.  He only contributed $16,000, but time and the power of compound interest were on his side.  Arthur contributed $76,000 over his lifetime, and with the same 12% annual yield, he ends up with only $1,532,166.

I know this is hard to believe and the numbers don’t seem to make sense.  The best way to really understand this is to see the numbers for yourself laid out in table form.  Click here to see this table via the kids section of Dave Ramsey’s website.  


Conclusion
There is no good excuse for anybody to not retire a millionaire.  It is not that hard to save $2,000 per year.  That works out to only $167 per month, or about $40 per week.  If you think this is an amount you just can’t afford, maybe you should ask yourself a question.  Can you afford not to do this?  As you could see in the examples, the earlier you start saving the more you will accumulate over time.  Of course you could invest more or less annually, and your results will vary depending on how and where you invest your money.  I hope you are reading this at the appropriate time in your life or career.  If not, surely you know somebody who is just starting out.  

Please share this with anybody you know who would like to retire a millionaire!  It would be irresponsible not to share the secret of compound interest.


References
Compound Interest definition: http://www.investorwords.com/1013/compound_interest.html#ixzz1Vwrm4t65

Financial Peace Book by Dave Ramsey -the new “Revisited” version via Amazon.com

Ben & Arthur example via Dave Ramsey’s web-site
http://www.daveramsey.com/media/pdf/forms/ben_and_arthur_military.pdf

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