Breaking with tradition, I’ll give you the moral of the story first: “Slow and steady wins the race”. Like you didn’t know that? But do you really understand it? The Greeks were pretty sophisticated mathematicians so it’s entirely possible that the concept of compound interest was already well understood when “The Tortoise and The Hare” was written. However, had they been sophisticated marketers the famous Aesop’s fable would have been converted into a 60 second spot for the local bank because it serves as a great example of how perseverance and responsible behavior really pay off when it comes to investing. And apparently we all need a 60 second spot like this to remind us of something that, at one level, is intuitively obvious.
I guess I needed to be reminded as well. Despite my quantitative background and the fact that I know all the formulas for calculating compounding it wasn’t until I read a Wall Street Journal article a couple of years ago that I finally put two and two together and realized the simple implication of compounding for investors: Start saving early.
Since a picture is worth a thousand words let’s do a simple example involving twin brothers Tory and Harry. Tory is the responsible one that starts an IRA at the age of 22, squirreling away $2,000 per year while Harry waits 10 years, figuring that he will quickly catch up to his brother by saving $4,000 per year. After all, it can’t be that hard to catch up to someone who only has a $20,000 lead, right?
So, to make the calculations easy let’s assume that the savings are invested at the beginning of each year and return 10% each year - reasonable assumptions. Here are the results over Tory and Harry’s lifetime:
Guess what? Harry never catches up - and for a simple reason. The income that Tory earns on his $20,000 head start exceeds the extra $2,000 that Harry is saving each year in perpetuity. By the time they both reach 65 Tory’s nest egg has grown to $1,435,810 while Harry’s account is a paltry $1,080,097. In fact, if Harry wants to have even a prayer of catching up he needs to start no later than 7 years after his twin brother. It’s no wonder that Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time”.
I was lucky in that I instinctively saved everything I could from an early age despite not fully appreciating what I was doing. But suppose you have followed Harry’s strategy for most of your life and now you’re looking at this example and you’re thinking it’s too late? Well, you can’t do anything about the past but every minute that goes by without a mid-course correction is another minute wasted. Start saving as much as possible right now! You can start by cutting back on the Starbucks. That has to be worth at least $1,000 per year.
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