The Power of Compounding

Remember all the time we spent as children dreaming about what it would be like to be a millionaire? Surprisingly, if we had spent that same amount of time running a candy store or a lemonade stand, we would all be on track. Why didn’t anyone tell us it was so easy! Of course, many adults don’t comprehend the power of compound interest, so I suppose we should give ourselves a bit of a break, but here is the secret: assuming historical investment rates of return hold steady, a 10-year old would need to invest only $25.52 a month during his lifetime to be a millionaire by age 65.

Regardless of your investment goals, the key to collecting wealth is to invest early and often. The S&P 500 has averaged an annual return of 10.36% since 1926. That average includes such tumultuous times as the Great Depression, the inflation crisis of 1973-1974, and the bursting of the tech bubble in 2001-2002. Assuming this rate of return, a 25-year old would only need to invest $141.66 a month to have a million dollar portfolio upon retiring at age 65. Compare these figures to a 55-year old who must invest $4,781.89 a month to have a million dollar nest egg at retirement and the benefit of investing early and consistently are clear.

These numbers are yet to incorporate one very important factor: inflation. After accounting for an inflation rate of 3%, which is representative of historical norms, the 25-year old investing $141.66 each month will have a nest egg of $387,866 upon reaching age 65. Assuming the individual will live until age 90, these savings will provide approximately $33,734 of inflation-adjusted income annually. This is a substantial amount, especially if these savings will be supplemented by an employer sponsored 401(k) or social security. (If you’re curious, a 25-year old would need to invest $365.23 a month to have an inflation-adjusted net egg of $1,000,000 upon reaching age 65, and that would grant the retiree an annual income of $86,973 until age 90). Further, assume the individual is married and their spouse followed a similar investment strategy since the age of 25. That couple would have an inflation-adjusted income of $67,468 annually until reaching age 90. This amount should be sufficient to support the couple even without additional benefits from social security or employer contributions to retirement accounts.

Armed with this knowledge, individuals should closely monitor their spending and savings habits. Ideally, investors should save between 10% – 15% of their gross earnings. If you are still having a hard time saving, consider this: a general rule of finance is that your investments should double in value every seven years. Thus, a 25-year old has the option of spending $200 on the new Rock Band video game, or investing that $200 and watching it grow to $400 at age 32, $800 at age 39, $1,600 at age 46, $3,200 at age 53, $6,400 at age 60, or $12,800 at age 67. I’m sure the game could provide hours of entertainment, but is it really worth $12,800 at retirement?

Developing a strategy to meet income goals is what financial planning is all about. Speak to a financial advisor to determine the amount you should be investing monthly to provide you with the retirement you envision.