November 7, 2008
Among the most valuable financial wisdom you can teach your kids is how to harness the power of compounding. This life lesson is best learned early because the payoff grows exponentially the sooner you start practicing it.
What is compounding? Basically, it's where you put aside money – whether in savings, a retirement account or the stock market – and then essentially leave it alone. As your account earns interest or dividends, you continually reinvest those profits, generating (compounding) additional earnings at an accelerated rate.
Numerous interactive calculators are available online to help you estimate potential savings under different scenarios. I used several at www.dinkytown.net/savings.html in the following examples, but similar tools are located on financial and investment sites across the Web:
How investments grow over time. Using the Dinkytown "Compound Interest and Your Return" calculator, you can estimate how quickly a one-time investment will grow at varying interest rates and periods of time. For example, $10,000 invested at an 8 percent annual percentage yield would be worth $21,589 after 10 years; $46,610 after 20 years; and $100,627 after 30 years.
Escalating impact of regular monthly savings. By setting money aside every month, your savings will grow even faster. According to the "Cool Million" calculator, if at age 21 you began saving $100 a month at 8 percent interest, by 65 your account would be worth over $450,000. Increasing the monthly contribution to $200 would double that to more than $900,000. And, by saving $300 a month, you'd reach $1 million by age 61.
Interest rates matter. The riskier the investment, the greater your potential gains – and losses. For example, regular savings accounts typically offer very low interest rates in exchange for very low risk of loss. On the other hand, investing in the stock market can potentially earn double-digit investment rates over long periods of time. Of course, stocks can be a risky short-term investment, as we've seen this past year.
So why not simply park your money in a safe haven? Simple: inflation. If your money is earning 2 percent interest but the inflation rate is 3 percent, you'll actually net a 1 percent loss.
Go back to the "Cool Million" $100-a-month example above. If you expect to earn 8 percent interest but factor in a 3.1 percent expected annual inflation rate, your account balance at age 65 would be worth more like $110,000 in today's dollars, versus $450,000-plus unadjusted for inflation. Furthermore, by reducing the expected annual interest rate to only 4 percent, your account balance would drop to around $140,000 – or less than $40,000 after adjusting for inflation.
A good financial advisor can help you devise a well-diversified investment strategy that will help you balance your appetite for risk with methods to beat inflation. If you don't know a financial planner, www.plannersearch.org is a good place to start looking.
Postponing savings can hurt. The longer you delay saving, the harder it is to catch up. According to the "Don't Delay Your Savings" calculator, if you saved $100 a month at 8 percent interest, after 20 years your account would be worth $57,266. But wait only two years to begin saving and that balance would shrink to only $46,865 – over $10,000 less. A five-year delay would reduce the balance to only $33,978.
Bottom line: Don't let the economic volatility of the last few months stop you from saving. And get your kids on the compounding bandwagon as well; they'll thank you in 20 years.
Recent Practical Money Matters