One morning during a recent trip, I was trying to wake myself up with some too-weak coffee in a hotel restaurant. Not helping matters was the boring article about retirement savings I was reading. The article was trying to demonstrate what someone earning a median salary, setting aside a conservative portion of that salary each year, and earning what a 60/40 stock/bond allocation has averaged over the past 40 years, would likely end up with when he retires.
It was all very predictable, until I got to this sentence: “By the time our median man was retirement age, his first five years’ worth of savings had grown to 25% of his retirement savings.” Whoa. While the percentage will vary based on how much is saved and the rate of return, this is a very powerful way of stressing the importance of investing as early as possible.
The usual ways of teaching about compounding
I thought I had seen all of the best examples of the power of compounding, and was using them in workshops. One slide I use shows what will happen if you invest $200 per month and earn a 10% average annual return. After 10 years, you will have saved $24,000, but through the power of compounding, it will have turned into more than $40,000. So far, so good.
Now give it more time. After 50 years, you will have invested $120,000 — impressive unto itself. But because of that 10% average annual return, compounding will have turned it into nearly $3 million! Wow.
Another slide compares two young couples. Both saved $200 each month and earned the same rate of return. However, the first couple started saving at age 20 and then had to stop after 10 years. They left what they had saved in their account, allowing it to continue growing at the same 10% rate until age 70. But they never added another dime.
The other couple had other financial priorities for their first 10 years. Besides, they figured, they’re young and would have plenty of time to invest later. At age 30, they started. They were disciplined about investing $200 each month until they were 70, and they generated an average annual return of 10%.
The first couple contributed to their account for 10 years. The second one did so for 40 years, setting aside far more money than the first couple — $96,000 vs. $24,000. However, at age 70, the first couple ended up with some $700,000 more than the second couple! Again, starting early makes a big difference.
A new way of thinking about compounding
Until that morning in a hotel restaurant, I had never thought in terms of emphasizing the impact of the first five years. It’s an especially powerful way of framing the importance of starting to invest as early as possible.
Let’s say a new college grad begins a job paying $50,000. She receives a 2% yearly raise, contributes 10% of her salary to her 401(k) each year, and earns an average annual return of 10%. In 50 years, her account will total more than $7.5 million. Impressive, right? (And that's with no company match!)
But what if we take away her first five years of investing? Her total drops to $4.6 million. In other words, investing a portion of her salary during the first five years of her career — a time when her salary was at its lowest — ends up being worth an incredible $2.9 million. That’s nearly 40% of her eventual total retirement savings. Now that’s a wow!
No matter how old you are, the same general advice applies: the earlier you start investing, the better. But the younger you are, the more impact starting early will have.
What young people do you need to share this with?
