Once in a while, it’s nice to have a little reminder about the magic of compound interest.
Say your goal is to become a decamillionaire ($10,000,000) in your lifetime. How much blood, sweat, and tears will you endure to achieve that goal?
Actually, not too much.
If you put $5,000 a year into a Roth IRA starting at age 20, earned 10% a year, at the age of 75 you will have accumulated $10,343,253 tax-free.
Not too bad for just $5,000 a year in just one investment account (Imagine if you did something similar with your 401(k).
If you’re over 20 years old and don’t plan on waiting to withdraw from your Roth IRA until 75, you’re not out of luck. While you shouldn’t plan on becoming a decamillionaire, you’re by no means headed for the poor house.
Say you started at contributing $5,000 a year to your Roth IRA at age 25. Once you turn 70 you will have accumulated $3,953,977. Again, not too bad for a small sacrifice of money.
Too Simplified?
This isn’t over simplification. This is investing. More specifically, this is compound interest.
What’s the purpose of telling you this? Well, a lot of people think they can’t accumulate wealth like this. That only lottery winners, athletes, movie stars, and CEO’s can make this much money. Even worse, that people who do accumulate this sort of wealth in their lifetime are bad people, work 100 hours a week, were lucky, and sacrifice their life in pursuit of money.
That couldn’t be farther from the truth. Anyone with the right mindset and patience can accumulate wealth over the lifetime.
This makes them smart, not a bad person.
Photo by: Enkhtuvshin
{ 10 comments… read them below or add one }
Hi RJ,
I find this post a bit disingenuous…a consistent 10% return over the course of 55 years seems very unrealistic. I don’t know if you saw this chart/article from the New York Times on the web earlier this week:
http://www.nytimes.com/interactive/2011/01/02/business/20110102-metrics-graphic.html
But the only time period reflected there that even comes close is investing in the early 1920s and cashing out in the 60′s – and even that is only around a 7% return. I totally agree that maxing out a Roth IRA is one of the best financial decisions you can make, especially starting early – but I highly doubt that will lead you to “decamillionaire” status.
I’ve always felt that the importance of investing (or at the very least, saving for the long-run) should be more intensely stressed to teenagers because of compounding. Though I started saving for retirement young at 21, I wish I had been more educated on the matter in my high school years. I’m sure some high schools offer classes in personal finance, but mine did not, and I have since felt that it should be standard, in the way that health class is mandatory. I think there is a lot to learn about finance BEFORE you’re financially independent, which happens to be when young people tend to make their worst financial decisions. Any thoughts?
@Tim – Thanks for sharing.
Here are a few problems I do have with it though and why I don’t think it’s damaging to use a 10% return, especially for longer periods like 40 to 50 years in a non-taxable account like an IRA.
1. Nobody only invests in the S&P 500 index fund. A good portfolio diversifed both domestically (Total stock market fund instead of S&P 500) and internationally.
2. That chart includes taxes. A Roth IRA is withdrawn tax-free. HUGE difference.
3. That chart says “average fees”. What is that supposed to mean? Since it’s a money manager who designed the chart, maybe he included his 1% management fee plus the additional investment fees. You don’t know.
4. Rebalancing has also allowed individual investors to decrease their risk and increase their reward.
Unfortunately, it’s pretty easy to tell the story you want people to hear with statistics.
I’m 20 and have opened a Roth IRA account but I really can’t afford to max it out right now
RJ,
While I agree with the basic premise of what you’ve written both in the post and comments, I do think you leave out one very important factor and the one factor we truly have no control over. That factor is what timing you have in saving your money.
While you might be able to average a 10% return over the time period (I would however not use this as a planning target), that 10% can result in wildly different total wealth outcomes depending on when you begin and end your saving. For example, someone who began saving and investing in the early 80s had a pretty darn good run for the first 20 years of their investing lives. Unfortunately, the past ten have been very poor. Someone may have been able to average 10% upside over that time period, but the majority of that return was during a period when the individual had a relatively small amount of money invested. Then when the individual had the largest amount at risk (they are running out of time to compound and have now saved a large pot of money), they no longer are compounding significantly. Or even worse they are experiencing negative compounding! Yep, it works on the way down also.
On the other hand, for Gen Y investors, they may experience the reverse. They began saving during the past decade in a very poor investment environment. Fortunately, they had little money at risk. If the future brings them far better returns so that they may be able to compound at a higher rate from here forward while their investments assets have begun to become substantial simply by saving, they will end up with significantly more financial wealth than the previous individual.
Investment outcomes are all about timing, not market timing, but simply the timing of when you begin and end your saving. Unfortunately, we cannot control this in any way and simply need to begin saving as early as possible and hope to be in a good investment environment in the last decade or so of our savings period.
-Nathan-
Interesting point, RJ. I think a lot of people don’t realize the potential of how investments can grow over long periods of time like 40 years. 10% rate of return aside, it’s interesting to entertain the idea that one can accumulate $10 million by only investing a realistic amount of $5k a year. Starting early and staying on track can really pay off in the long run (even if you don’t want to be a decamillionaire).
When I get discouraged about investing, I’ll go to a compound interest calculator and run these kinds of number. It helps keep me sane when I start missing the money I’m throwing at my investments every month. Thanks for the article!
-Pat
http://compoundingreturns.blogspot.com
- Any mention of inflation has been totally left out of this savings strategy.
- A 10% return for 55 consecutive years is totally unrealistic.
- Left out is the opportunity costs that come w/using the money early on to store in your IRA vs educational spending to upgrade your own skill set or starting your own business.
Maxing out your IRA can be considered a good strategy, but the supposed rewards in this article are full of hyperbole.
Hi RJ,
This is an interesting article and one that I enjoyed reading because it highlights the absolute importance of compound interest. I can see that some of the comments are around whether or not 10% interest is accurate, it’s not something that I have an understanding of enough to really comment on, but the key takeaway for me is highlighting the importance of compound interest.
I do wish wish I had a better understanding of personal finance when I was younger but I am certainly trying now, and it’s posts like these that keep me motivated.
Cheers
RJ- Very interesting (both the post and comments). This bums me out a bit b/c I am starting let’s just say later than 20!
But we have been wiping out our debt in the meantime.