PERSONAL INVESTING: The Best Time to Start Investing

 

TIME IS ON YOUR SIDE

·        How compounding impacts on returns over time

·        The importance of investing early and often

As discussed in the previous lesson, investing is a strategy typically used when faced with goals requiring a lot of money and often far in the future.

Achieving such goals is made easier by what Albert Einstein supposedly called the most powerful force in the universe—the power of compounding.

Rather than just giving a definition for compounding, let’s look at a problem: Maria and Bob are both 19 years old and want to save for their retirements at age 65. Maria plans to invest a total of $16,000, while Bob plans to invest a total of $78,000. Using different investing strategies, who will have more money at retirement?

Let's assume that Maria and Bob both earn the same rate of return—the gain on an investment expressed as a percentage of the original amount invested.

In this example, the rate is set at 10% per year. So if they each invested $1,000 now, they would earn how much after one year?

$1000*10% = $100

So, who do you think will have more money when they're 65? Bob does seem like the logical choice since he has more money to invest, but we'll show you how Maria can end up with more money, all thanks to compounding!

Using a spreadsheet will make it easy to see who has saved more money. There are columns for Maria and for Bob. We'll stick with a 10% per year rate of return.

Here's a portion of the spreadsheet. Which areas highlight the difference between Maria's and Bob's investing strategies?

Right! Bob didn't start investing right away! Maria invested $2,000 when she was 19, and Bob didn't invest anything until he was 27.

Yes! Maria starts investing right away.

Maria invested $2,000 at age 19, and she earned 10% or $200 at the end of the year for a total of $2,200.

At age 20, she invested another $2,000 and earned 10% on both the new $2,000 plus the $2,200 from the previous year for a total of $4620 at the end of the second year, and so on.

Maria used up her $16,000 at age 26 and doesn't have any more money to invest. Bob began investing at age 27. After his first year, Bob's total value was $2,200; after the next year it was $4,620; and so on—just like Maria's.

By age 40, Maria has long since invested all of her $16,000. By the same age, Bob has invested $28,000 and is still adding $2,000 per year. Yet, who has more money at age 40? At age 50?

Yes, Maria has over $30,000 and $50,000 more than Bob in each of those years, respectively.

Despite not investing anything since age 26, Maria has more money at age 65 with a total of $1,035,160.

Bob has been putting in $2,000 each year since age 27, yet he only has $883,185 at age 65. That's the power of compounding!

For comparison, look what happens if Maria had kept investing $2,000 each year. By age 65, Maria would have invested $94,000 compared with Bob’s $78,000—a difference of only $16,000. But compounding translates that difference into an additional $1 million dollars by age 65.

Einstein was right, compounding is a very powerful force indeed.

Compounding is the process of an investment earning a return which then earns its own return, over and over again—returns on the returns. This is the reason why it is so important to start investing early and let time work for you.

IN SUMMARY:

Compounding is earning a return on an investment's return

Rate of return is the percentage gain or loss on an investment and the best time to start investing is early and often.