If we were to teach a class on retirement investing, our first lesson wouldn’t be about stocks. Or bonds. Or asset allocation, products or even account types. It would be about one powerful concept that too few investors truly grasp: compound interest.
Compound interest is the strongest force in investing, in our view. It is essentially why investing, over the longer term, works. You invest a certain sum, it earns a return, and then you earn a return on your returns. It is a means to turn a relatively small sum into a large retirement portfolio over time. Here is a simple chart that demonstrates the point.
Exhibit 1: $4000 Annual Contributions Compounding for 30 Years at Various Rates
Source: Fisher Investments
After 30 years of saving $4,000 annually, you’d have contributed a total of $120,000. But with growth of 8%—a bit below stocks’ annualized return since 1926, that $120,000 would have grown into $489,383. Even a mere 4% annualized growth rate—a pretty terrible 30-year rate of return—would almost double your principal investment.
Why does this matter? In many cases, retirement planning is a long-term business. Even if you are retired, you may still have 20 or 30 years to fund. So, maintaining a strategy that harnesses compound growth—particularly when you are not actively contributing any longer—is key! You can also see how critical it is to start retirement planning and investing as early as possible.
Maybe you or your kids are recent college graduates. Heck, maybe your grandkids are! If so, here is some advice worth sharing: The sooner you start saving for retirement, the better your retirement is likely to be!
Exhibit 2 illustrates this point by creating two hypothetical savers. Bill starts his retirement investing at age 22, and Ted waits until the still-young age of 30 to start investing.
Exhibit 2: The Cost of Waiting to Invest in Retirement Planning
Source: Fisher Investments
By waiting eight years, Ted’s retirement portfolio is smaller than Bill’s by more than half a million dollars! And Bill gained that extra half a million dollars by investing only $32,000 in those first eight years! For Ted to equal Bill’s $1.2 million retirement portfolio by age 62, he’d have to invest twice as much annually ($8,000). That means Ted’s total principal invested would be $320,000 versus Bill’s $164,000. That is the power of time and compound growth! Now, alternatively, Ted could wait to retire, allowing his portfolio more time to grow. But for one thing, that’s probably a lot less fun than Bill is having. And for another thing, these examples are all just straight-line hypothetical calculations. There is no guarantee stocks will have a good decade at the end of Ted’s working years.
Now then, you could say the same for frugal Bill, who saves early. Maybe that decade turns out to be awful. But he would still start the next 10 years with money in the bank versus none, and it’s a much safer move to start saving early rather than late. Even if you are retired and aren’t actively saving, we humbly suggest a family member of yours might benefit from this free advice: A million-dollar retirement is cheaper if you invest sooner.