Albert Bartlett’s quote, “The greatest shortcoming of the human race is our inability to understand the exponential function,” encapsulates a profound truth about human understanding and financial growth. The principle of compounding, represented by this exponential function, is a potent force that can lead to substantial growth over time. However, our instinctive grasp of linear progression can often make it challenging for us to truly understand and appreciate the impact of this exponential growth. It’s a concept that’s simple mathematically, yet psychologically elusive, often leading us to underestimate the potentially massive outcomes of repetitive, compounding increments.
Charlie Munger, the Vice Chairman of Berkshire Hathaway and a seasoned investor, once said, “The first rule of compounding: Never interrupt it unnecessarily.” This succinct piece of advice underlines the importance of patience in the process of wealth accumulation. By letting your investments compound unhindered, you allow the exponential growth to work in your favour, leading to an impressive accumulation of wealth over time.
To illustrate the power of compounding, consider this example: if you begin contributing $100 monthly to an Individual Retirement Account (IRA) starting at 18 years old, and continue this until you reach 65 years old with an annual growth rate of 8%, you would accumulate a staggering sum of over $1.5 million by the time of retirement.
Now, let’s take this example a step further. If you increase your monthly contribution from $100 to $500, while maintaining the same conditions—an annual growth rate of 8% and a consistent contribution from age 18 to 65—the results are even more astonishing. With this increased investment, by the time of retirement, you would have amassed an astounding sum of over $7.5 million. The more you contribute, and the earlier you start, the greater the exponential growth experienced, leading to a significant wealth accumulation over time.
Staying committed to a long-term investment plan is greatly facilitated by having a durable portfolio. A durable portfolio, characterized by well-diversified and quality investments, can weather market fluctuations and provide consistent returns over time. This consistency helps maintain investor confidence, reducing the temptation to prematurely withdraw funds or make erratic investment decisions driven by market volatilities. By preserving and enhancing the capital, a durable portfolio ensures that the forces of compounding continue unhindered, allowing investments to grow exponentially. The combination of a long-term investment strategy, a robust portfolio, and the power of compounding is a potent recipe for significant wealth accumulation.
The Power of Time
What captures my attention as a financial planner charged with helping clients balance the needs of today with the needs of tomorrow is how little is actually needed each month if you start saving early enough. $500 a month uninterrupted has a HUGE impact. And that leaves room in the budget for allowing you to also enjoy life TODAY.
Dave Ramsey’s quote, “If you are willing to live like nobody else today, you will live like no one else later” emphasizes this value of financial discipline and forward-thinking. This statement encourages people to make financial sacrifices in the present—such as saving more, investing wisely, and avoiding unnecessary expenses—which may set them apart from their peers. These prudent choices, though potentially difficult and uncommon in the short-term, can significantly enhance their financial stability and freedom in the future. The quote underscores the long-term benefits of such a disciplined approach, suggesting that those who follow this path can enjoy a comfortable, worry-free lifestyle in their later years—akin to ‘living like no one else’.
I wish someone had explained that to me at 18! Again, assuming an average annual return rate of 8%, the total amount I would have contributed would be $156,000 over these last 26 years. However, due to the compounding effect, the final balance of the IRA would be much higher. In fact, it would have accumulated to an impressive $615,580.69. This dramatic increase exemplifies the magic of compounding where earnings are reinvested to generate their own earnings. The earlier one starts, the more time there is for compounding to work its magic, turning disciplined, regular investments into a significant retirement nest egg.
The Danger of Waiting
Let’s consider now the case of an investor who waits until they turn 40 to start saving for retirement. They manage to put aside $1500 every month, investing it in a fund that offers an 8% annual return, compounded annually. Despite starting late, they are committed to making substantial contributions to their retirement fund. However, the delay in starting their investment journey comes with a cost. If they continue this saving strategy until they’re 65, they will have contributed a total of $450,000. Given an annual return rate of 8%, their retirement fund would grow to approximately $1,359,000. While this is a sizable amount, it’s significantly less than what they could have amassed had they started investing just $500 (or 1/3 the monthly amount) at age 18, demonstrating the lost potential caused by waiting to begin saving and investing. This serves as a stark reminder of the importance of starting one’s investing journey as early as possible to fully leverage the power of compounding.
Time vs. Timing
Many investors tend to believe that timing the market – buying low and selling high – is the key to growing wealth. However, this strategy is fraught with uncertainty and risk, and even the most experienced investors can find it challenging to consistently get it right. The principle of “time in the market” outshines “timing the market” in the long run. The former emphasizes the importance of staying invested for a long period, allowing investments to grow and compound over time. Regardless of the market’s short-term volatility, investors who stay invested for an extended period are more likely to experience higher returns. This is due to the potent combination of compounding and time, which consistently builds wealth. Thus, when it comes to investing, especially for long-term goals such as retirement, time in the market indeed triumphs over timing the market.
When it comes to investing, time is the most potent element at your disposal, and compounding is the magic that it wields. Just as a tiny seed, given time, can transform into a towering tree, so too can a small, regular investment blossom into a substantial nest egg. Let the power of compounding run wild. Start investing early, even if the amount seems insignificant, and let it grow. Over time, you will be amazed by the power and potential of your own money to multiply. Remember, compounding doesn’t ask for a big bang start; it asks for consistency, patience, and time. Harness the power of compounding, and let your money work for you.
Brannon is a financial advisor with LPL Financial and also serves as the team’s wealth manager. He joined Prosperion Financial Advisors in 2004. In addition to being a Certified Financial Planner® (CFP) and an Accredited Portfolio Management Advisor®, Brannon has a Master’s degree in Leadership from Denver Seminary. He is passionate about helping clients make wise, informed, investment and financial planning decisions. He is married to the love of his life, Melanie, and is the proud father of his son, William. When not working with clients or spending time with family, Brannon enjoys being in the outdoors of the Colorado high country, skiing, fly fishing, and exploring wild country.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
All examples are hypothetical and are for illustrative purposes.
Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all market environments.
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