Compound Returns in Action

On 12/11/2009, in Investment Concepts, by Jordan Wilson

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.

The key is to start when you are young. The amount that you invest is somewhat less important than the time frame.

Prudently invest on a consistent basis and let the power of compounding do its thing. We will examine what might constitute “prudent” investing in early 2010.

If you want a refresher on the power of compound returns, please check my earlier posts on the subject located here and here.

If you are up to speed, please consider the story of Nicole and Matt.

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 8% per year in a family of no-load diversified mutual funds that reinvest any income earned back into the funds.

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% compound return.

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% compounded annually.

At age 70, Nicole terminates her individual plan. Imagine her surprise when she discovers that her asset balance is $1.05 million.

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

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 did, 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 to the one Nicole undertook. 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 age 70 and become a millionaire, Matt will have to invest $700 per month for 30 years in an account earning 8%.

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

To catch her, Matt must invest $252,000 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. A lot more sacrifice for Matt to become a millionaire.

That is the power of compounding.

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

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

Next up in this look at compound returns, ways to improve your net investment returns (i.e. the money you can reinvest and compound) by reducing your investment expenses.

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