This post was originally titled “Compound Interest and Delayed Gratification,” but my marketing brain quickly realized that “How To Make a Half Million Dollars” would grab your attention much better. Did it work?
Compound interest and delayed gratification? What in the world? Aren’t queers famous for their joie de vivre, their focus on enjoying the present? For flocking like moths to a flame to stories about Lady Gaga’s new video and eschewing boring finance stuff? This sounds like two topics designed to cure insomnia. And what in the world do they have to do with each other, and more importantly to you? When combined these two concepts can make you rich.
First let’s start with compound interest. Simply put this means that when you have money that is earning interest, and you reinvest the interest (and don’t touch the principal), the total of your money starts to climb exponentially because you start earning interest on your interest. Pretty cool and pretty powerful over time.
Let me illustrate. About 15 years ago I started working for a strategy consulting firm right after getting my MBA. I was living in a new city, outfitting a fab new apartment, and it was tempting to spend all of my new salary. But no, instead of spending it all on stylish new furniture or a new sound system I put $12,000 into the company’s 401k. And the company matched it. I’ve left that money there all these years and did not roll it over co-mingle it with other money, so it’s easy to know exactly how it has grown. And guess what. Even after all of the market gyrations of the intervening fifteen years, that money is now worth about $120,000. Not bad, huh? Is it because I’m an investing genius? No. It’s because of compound interest.
The formula to determine the future value (FV) of an investment you make today is quite simple. All you need to know is the amount of money you have to invest (PV = present value), the earnings or interest rate you expect (i = interest), and the time frame (n = number of periods corresponding to the interest rate – either per year or per month).
FV = PV (1 + i)^n
In my case just looking at the money I put in, I have earned about 16.6% per year on my money.
$120,132 = $12,000 (1 + .166)^15
Now that’s a pretty good return, considering that you can’t get that return on your money in a savings account. And while that’s truly the return on the money I saved, you have to remember that my employer matched my contribution, so I actually had $24,000 in the account to start with. Using the total invested amount, the return over these years is about 11.35% per year. That’s just a little bit better than the long-term return on equity of about 10%. Investing genius? No. Making compound interest work for me – yes!
$120,383 = $24,000 (1 + .1135)^15
Here’s the other little secret. That $12,000 saving I made in the beginning only cost me about $8,000 out-of-pocket. Why? Because it was in a tax-advantaged saving account, so my contribution was deducted from earnings before my tax was calculated. In essence Uncle Sam gave me $4,000 on which the principle of compound interest could start earning me money. When you look at my true out-of-pocket cost of $8,000, my average annual rate of earning on this money has been about 19.8%. Pretty phenomenal, really.
And if this account earns at the 10% equity average for the next 15 years, guess how much it will be worth?
FV = $120,000 (1 + .1) ^15 which equates to just over $500,000. That’s right. My little $8,000 out-of-pocket investment will be worth about half a million dollars.
Got it? The only way you’re going to build up your wealth is to save money now. The difference between starting to save early (even when you think you can’t) and even a few years later is enormous. In fact barring some sort of windfall it’s impossible to catch up with the early savers! So make sure that your commitment to save starts today. And if you are fortunate enough to have an employer-sponsored retirement savings program like a 401k where your employer matches a portion, make sure you save as much as you can and you max out your match amount. And if you don’t, you should check out opening up a traditional IRA, or a Roth IRA (you put in after tax but don’t have taxes when you take out).
Sounds great, right? But what if you don’t have any money to put into savings today. That’s where delayed gratification comes in. Saving has to be your first commitment on every paycheck. If you can defer purchases and watch your money closely, you can put aside money and start watching it grow.
Actually the principle of delayed gratification has some wonderful applications besides just in money and budgeting. I actually use it in my daily activities. I’m a “To Do List” junkie. I make one every morning without fail. It’s so bad that a boyfriend used to sneak into my office and put his name on my list! But here’s how I use delayed gratification. I split my tasks up into things that take no longer than 30 or 45 minutes. And I always try to have a set of items on the list that I actually love doing. It might be reading a chapter of a novel in which I’m totally engrossed, or reading a few pages of a current magazine, or calling a friend. Then I only let myself do a “fun task” after I’ve done one of the other things on the list that I need to do but isn’t really fun. I reward myself for accomplishing that other thing with a fun thing. This not only motivates me to start the less fun task by putting a positive thing on the other side, it creates positive momentum for the day. Give it a try!
The point is that the only way you can guarantee that you have money to invest now is to make sure you have money to invest. By living below your means this is in your control. You’re not dependent on a bonus at work, or winning the lottery, or inheriting money. By deferring expenses and living more simply, you can save money today and watch it grow into a powerful investment portfolio.
To Your Good Wealth!