While I have a very mathy background to begin with, I’ve recently been mesmerized by how powerful compounding returns are when it comes to investments. Ramit Sethi does a great job of pointing this out in his book I Will Teach You to be Rich with a very simple example: Simple Sally invests $100/month for 10 years starting at age 25. Dumb Dan invests $100/month for 30 years starting at age 35. Each earn an 8% rate of return, which is about what the stock market returns annually. The difference : at age 65, Sally has $200,000 and Dan only has $149,000! That’s right, even though Dan invested 3 times more out of pocket, Sally has him beat by $50,000.
Many only dream of ever being a millionaire. Thanks to compounding returns, you don’t have to actually save $1 million to be a millionaire. If $5,000 a year is invested in a Roth IRA starting at age 20, there will be almost $2 million in your account by age 65!
This says only one thing to me: You need to start investing as soon as you can! The mathematical evidence of compounding returns clearly shows that you are at a disadvantage if you start investing later. It’s really hard to make up for the time lost in years later, even if you throw more money at the fire.
You may worried about investing when the market is having a bad year and the Dow is dropping. There’s no cause for concern, as this factor is definitely not as important as simply getting your money invested. A few points on this:
1. Unless you’re Warren Buffet, timing the market is difficult and totally unnecessary.
2. If you invest early (and over a longer period), you’re are much less susceptible to sharp fluctuations that occur during shorter periods. Yes, the stock market sucked in 2008 and killed a lot of investments, but, before that, returns were fantastic (and they’ve actually been good in 2009 and 2010, too).
3. Most people don’t invest large, lump sums of money all at once. Instead, a portion of monthly income is invested, so you’ll be constantly investing in good months and bad. Don’t worry, you have point #2 on your side.
4. If you suddenly have a big chunk of money to invest, you can use dollar cost averaging to spread the risk. I won’t get into too much detail here, but you can read more on dollar cost averaging at Get Rich Slowly if you’re interested.
Just Get Started!
No matter what your age, you need to get started now to take advantage of compounding returns! Here’s what to do:
1. Open an investment account if you don’t already have one. I have one with Fidelity, but others like Charles Schwab work grat, too.
2. Open a Roth IRA. This will take about 2 minutes.
3. Link to your checking account. Again, quick and easy.
4. Set up automatic withdrawals from your checking account to your Roth IRA. Even if it’s only $50 a month, just get started.
5. Choose an mutual or index fund. Don’t get bogged down by this. Investing isn’t as complicated as you think. Specific investments are outside the scope of this post, but I recommend I Will Teach You To Be Rich or Your Money: The Missing Manual to help pick out a lifestyle or index fund. You don’t have to pick an investment fund on day 1. Just start sending money to your Roth IRA and invest it as soon as possible.
6. Reap the benefits when you’re ready to retire.
I hope I’ve convinced you that compounding is really powerful. Not to be a downer, but it’s also really powerful on your credit card balances, too. Keep that in mind, and always be sure that compounding is working for you, not against you.
If you’re interested in investigating more compounding returns and interest scenarios, head over to dinkytown.net