Thursday, September 11, 2014

Save Early, "Know the Score" and Benefit from the "Last Doubling" ... The Magic of Compound Interest and the Rule of 72 ... Growing Rich Slowly

Our nation's high school graduates are often well advised to go to college. Among other things, most college graduates do much better financially than non-graduates over a working career. That's a fact.

Unfortunately, too many college graduates will accumulate a substantial amount of student loans prior to graduation. That's also a fact.

The goal of a college attendee should be to get the college degree and skip the debt while doing so. That's the tricky part, but it's a huge lifetime benefit.

In short, debt avoidance or minimization for the college graduate is absolutely doable and very much worth doing. And the "magic of the last doubling" is the reason why.

What's wrong with growing rich slowly? has the story:

"For young people who are just starting their asset accumulation journey, the most valuable asset they own is time and the most powerful tool at their disposal is compound growth....

(The story of) Stan and Ollie, 21-year-old twin brothers just beginning their professional careers, and their sister Lucy (is very much worth considering).
Getting an early start
Stan is the prudent brother. He knows that beginning to invest at a young age maximizes his chances of being able to retire at the time and in the lifestyle of his choosing. He starts contributing $5,000 each year to a Roth IRA. After 10 years, his contributions have totaled $50,000. Ollie is a perennial procrastinator and saves nothing during the first decade of his working years. Ollie then has a Prodigal Son moment. He realizes that he has been wasting time and squandering money long enough. So he decides to begin annual $5,000 contributions to a Roth IRA.

After making contributions for 10 years, Stan finds that the expenses of Homeownership and raising a family leave him with no money to invest. So from this point until retirement he makes no further IRA contributions.

Let us assume that both accounts yield a 7% annualized rate of return and that Stan and Ollie work for 45 years. At retirement, which brother will have the larger IRA?

Stan's contributions totaled $50,000, and when he ceased contributing to his Roth IRA it was worth $69,082. Ollie's Roth contributions amounted to $175,000. Upon retirement, Stan's Roth will have grown to $737,000 while Ollie's will be worth $691,000. Intuitively, it seems that this cannot be true.

With a 7% rate of return, an account will double in about 10 years. When Stan stops his contributions, enough years remained for his account to double three times. By the time Ollie has made $50,000 in contributions, he is 25 years from retirement and his IRA has time to double only twice. As we can see from this simple example, compound growth rewards early contributions more than later, more frequent ones.

When growing rich slowly, it's the last doubling that puts you over the top.
Doubling down
Lucy is a college student looking for a summer job. She is offered a position for 30 days of work. Her prospective employer gives her the following salary options:

1) Upon completion of 30 days of satisfactory employment, she will be paid $5 million.

2) She will begin employment with an initial salary of one penny a day and her salary will double each day for 30 days.

Which option should she choose?

By choosing the second option, her total pay for 30 days will be $10,737,418. Even as late as day 21, her daily salary is only $10,485. On day 29 her cumulative salary finally exceeds $5 million. And her pay on day 30 will be $5,368,709. Once again, that last doubling makes a huge difference.

Accumulating retirement assets is a marathon journey during which emotions are your enemy and time is your ally. The wealth created by long term compound growth is available to anyone with the patience, discipline and long-term optimism that it requires. The most successful investors I know have maintained a long-term view and let compounding work its magic....

Albert Einstein, no slouch when it comes to number crunching, is reported to have said that the most powerful force in the universe is compound interest. And perhaps growing rich slowly is the most unappreciated benefit of patient, disciplined, long-term investing."

Summing Up

Understanding the power of compound interest should be required knowledge for every student graduating from high school and prior to entering college --- and for his or her parents as well.

The negative effects of financial illiteracy and debt accumulation on the young are enormous and hugely destructive --- and because that's largely avoidable, it's also shameful.

Our youngsters need to "know the score." Achieving basic financial literacy is not hard.

And although not generally taught in school, understanding the power of the "last doubling" is critical to the young graduate's future economic health and well being.

How many course offerings, including those offered in both high school and college, are as important as basic financial literacy? Very few, I would argue.

That's my take.

Thanks. Bob.

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