We’ve talked about compounding before on this site, most recently with the doubling penny!, but here’s another way to help get it to sink in more. And in a nice and nerdy way at that.
(Don’t you have to see something like 7 times before you “get it”? Or is that just a marketing thing? If so, we’ve got 5 more articles to go! Haha… but I’ll let you off the hook early with good behavior ;))
This popular trick is called the Rule of 72, and I’m going to let my new friend, Mr. “Good Looking, But Not Quite Sexy, Budgeter” share it with you because it was he who emailed it over in the first place. If you like it, you can thank me later for posting it up. If you don’t, direct your comments to him ;)
The Compounding Rule of 72…
Hi, I’m almost sexy (lacking rainy day fund), so I’ll have to pass off as a “good looking, but not quite sexy, budgeter.” I had a idea for a blog that you could add to your queue of 120 ideas I wanted to share with you. It’s really the only investment advice I ever give out, and seems to be right up your alley.
If anyone asks me for advice in investing (it’s happened 2 and half times. One time, I misunderstood the question), I tell them how Albert Einstein called Compound Interest the 8th wonder of the world. Granted, he was a theoretical physicist, not a financial advisor, but I’m sure if he wanted to give us advice on how to bake Bundt cakes or how to throw a slider we’d listen.
The Rule of 72 is my favorite way to explain this concept:
You take 72 divided by a rate or return and it will tell you how long it would take that money to double (or for the purchasing power to cut in half, in the case of using inflation rates).
I’ll use 7.2% for my example because the math is easy. That means our investment will double every 10 years. When explaining this to people in real life, I’ll draw out on a cocktail napkin a chart showing the ages of an investor: 25, 35, 45, 55, and 65 across the bottom.
I ask them to pick a number to invest at age 25. $2,000? Okay, let’s plot that here at age 25. At age 35, that will double to $4k… then $8k, and so on until we get to $32k. I’ll connect the dots, which reveals a steady incline with a VERY steep curve at the end.
For effect, I’ll even purposefully make a “mistake” which requires a second napkin to be able to fit the return in the last ten year period, so it’ll look like this:
[Thank you MS Paint!!]
“Pick any 10 year period on this napkin… ” I’ll say. “Which 10 years do you like the return on investment the most?” Everyone (both people) points to the last 10 years leading up to age 65.
The lesson is obvious…start earlier and earn great returns later. Keeping $2,000 today foregoes $16,000 later. Imagine what the curve looks like when you add $2,000 EVERY year? Now figure this with 15% saved instead of just $2,000? The numbers start to get impressive.
[EDITOR’S NOTE: Remember our post on just doing one thing every year, like maxing out your retirement account(s)? I’d like to see how many napkins you need for that!]
I’ve convinced myself of this strategy so much that I’m not even planning on investing very much money in that last 10 years. Instead, I’ll opt to take a step down in my career to do something that gives me much more free time to do the things I want. Which, luckily for me, only require free time as the asset – not money (camping, hiking, etc.).
Something to think about on this beautiful Memorial Day! Doing stuff in life that’s important to you vs. slaving away for the almighty buck.
I’ll leave you with one last mind blowing piece on the magic that is compounding… Consider this pimping #3 so we’re already halfway there ;)
Courtesy of AWealthofCommonSense.com:
As Warren Buffett closed in on age 60 in 1989, his net worth was $3.8 billlion according to the Forbe’s List. This year, as Buffett approaches his mid-80s, he’s worth $58.5 billion. That means nearly 94% of Buffett’s current net worth was created after his 60th birthday.
[Top photo by Beau B]
Featured savings tip
You already know that banks pay $$$ for the privilege of holding your money…it’s called interest. But maybe you didn’t know this: that so-called interest can be as little as .01%. If your cash savings aren’t sitting in a high interest savings account that earns you at least 1%, you’re basically saying “no” to free $$$!
Now, obviously the 1% interest you get with a high interest savings account like the one at Discover bank won’t make you rich, but that extra 1% compounded over 30 years can grow into a *big* pile of cash. And if you wanna hit lofty $$$ goals, you should be looking for every edge possible.
Here’s another way to look at it: if you leave $50,000 in a regular savings account, that’s almost $500 you’re just throwing away, each and every year you don't setup a high yield savings account! Will you do 5-10 minutes of work right now to earn an extra $500/year for years to come?
If you said “heck yes”, then you can setup your high interest savings account here to start earning 1% on your cash savings.