This may come as a shock to you, but you were born with a super power. Not super strength or the ability to fly, but one that can make you and your family as strong as Bruce Wayne. It is something that all of us can do, but few of us learn to control. It is learning to master the power of compound interest and time. I know, I know. So completely not sexy. It does not come with a super suit or a catchy name (CI Woman? Interest Man? – sounds like a costume for an accounting party). But don’t be fooled, compound interest can be a force to be reckoned with. It is surprising that so few of us avail ourselves of its awesome power.
Let’s look at a few well-traveled examples.
The Price of New York City
If you are from the United States and have taken any history classes, you will recall that Peter Minuit negotiated the purchase of Manhattan Island from the natives in 1626 for trinkets equal in value to 60 Guilders at the time (Dutch Currency). In today’s dollars that is a bit more than $1,000. Anyone would say that this investment was a fairly astute purchase with the land value of Manhattan approaching $2 Trillion today. However, if Peter had taken that money and invested it at 7% (a figure I chose from historic market returns allowing for taxes), the resulting sum is a staggering $300 Trillion in today’s dollars. Now it took 391 years to get there, but it does illustrate the value of interest compounded over time.
The Price of Playing the Lottery
A more real world example. When I first started out in legal practice my assistant was a 22 year old just out of college. She would spend $5 each week playing the lottery. As hard as I tried, I could not get her to see the futility in spending that money. That is, until I created a spreadsheet (no easy task back then) showing that her $5 indulgence, spread out over her working life, was costing her more than $180,000 in retirement savings. (Note: She was not fully funding either her 401k or her IRA – she didn’t have the money :-/ ). I can only hope that now, many years later, she is well down the path to FI, and not trusting her retirement to Powerball.
Hacking Your Child’s Financial Future
One of my favorite financial system hacks is to arrange for a child in their first year to get some earned income (infant modeling is a great way – who does not like baby pictures? – but how is not important, only that the income is “earned”). A child who opens a Roth IRA with $5,500 in their first year of life, given historic stock market returns, and provided they do not raid the account later in life, will have better than $3.9 Million in that account at the age of 70. And that does not take into account future contributions. That is $3.9 Million out of $5.5 Thousand with nothing but patience, and compound interest.
These examples show how compound interest can truly be a super power. Warren Buffett has noted that his fortune is due entirely to “ . . . a combination of living in America, some lucky genes, and compound interest.” Who are we to argue with he Oracle of Omaha? But how do we take advantage of this super power? How do we board the supercharged bus of compound interest and let it take us to the promised land? The answer is simple: Patience.
Part of the problem with building wealth in our society (including saving for retirement) lies in our almost basic need for excitement and thrills. It’s like we have been programmed to seek risk. Patience is a skill not easy to find when confronted daily with advertisements talking about the excitement of day trading or hedge funds, penny stocks or commodities futures. It seems to be deeply rooted in our DNA to need some adrenaline fueled excitement or adventure. To miss it bores us, and makes us feel as if we are missing out on something vital. A little excitement is a good thing. That’s what amusement parks are for. But let’s be perfectly clear about one thing: This notion does not, nay, can not apply to your money. With your money, patience and time , and only patience and time, will allow you to get where you want to go, to achieve your life’s financial goals. There are no short cuts (I know, I spent too many years looking for them). This is how you use your super power. It’s the only way, and it can take you to the top if you use it correctly.
How about those of us in the gray hair zone. How does compound interest serve us? (If you haven’t read the post Five Years of Cash, take a look – it discusses this direct issue). For those on the front end of retirement or who are about to enter that phase, any amount of time you can delay taking your invested assets out of the market, is using your super power. It gives your assets additional time to grow.
Let’s assume that your total invested assets are $1 Million. At historic stock market returns, leaving your assets invested for an additional 5 years increases your assets to $1.6 Million (assuming 10% per year on average in a tax deferred/free account). Using the 4% rule (which I have issues with, but that will be a subsequent post) this extra time increases the annual withdrawal from your invested assets from $40,000/year to $64,000/year, solely by allowing compound interest to work its magic. That is part of why I think it is so important to have a few years of living expenses set aside outside of your invested nest egg. Every year you delay using your invested assets either increases the amount you have, or gives you a chance to recover from a market decline (again, read Five Years of Cash).
Until Next Time, FIRE On! – Oldster
