Using Compounding To Overcome A Shortfall In Retirement Savings

I believe financial advisers often seem to assume their clients have a time machine. They like to explain that, with enough time, anyone can enjoy a financially secure retirement. For example, if you invest $200 a month every month for 40 years, your account will be worth $1.2 million if stocks gain an average of 10% a year.

The math behind that calculation is correct, but there are two big problems in the real world. The first problem is that most of us don’t have 40 years before retirement. The second problem is that those with 40 years until retirement, young people in their 20s or 30s, don’t have money to invest for the future when their bills need to be paid every month.

Fortunately, the math financial advisers use is correct, so no one’s situation is hopeless.

I’m not saying all the math financial advisers use is correct. Much of it is too risky for my taste. Especially when they talk about how to handle your finances in retirement. Standard advice creates a high risk that you’ll run out of money. But that’s a story for another day.

Today, I want to focus on just one small piece of what advisers talk about.

Wealth grows over time because of compound interest, a principle Albert Einstein supposedly called the “eighth wonder of the world” or the “greatest invention of mankind.” In all likelihood, Einstein never said anything like that, but compound interest is the key to wealth accumulation.

Compound interest is simple to understand.

If you invest $100,000 and earn 10% a year, after one year, you have $110,000. That includes the original $100,000 plus $10,000 in interest.

If you “let it ride” the next year, you will make $11,000 since you earn 10% on $110,000. At the end of the second year, you have $121,000.

At the end of the third year, you have $133,100.

With simple interest, if you earn a straight 10% return every year, you will only have $130,000 after three years. Simple interest pays you only on the original investment. Compounding pays interest on the interest you already earned.

Compounding starts small, adding just a few thousand dollars to your account in the first three years.

Over time, these small differences add up. In 25 years, with compound interest, that $100,000 would grow to $1,083,000. With simple interest, the account would only be worth $350,000.

Great investors take advantage of compound interest, but the world’s greatest investors are really different from average investors. At the most basic level, they just see things differently. Compound interest can illustrate that point.

There is no arguing with the value and importance of compound interest. But there is nothing magical about that one-year time frame. The world’s greatest investors don’t think in terms of years; they might think in terms of weeks or months, compounding wealth faster by continuously making new investments that generate profits they can reinvest.

Jim Rogers is an example of how to grow wealth fast. In 1968, Rogers started investing with $600. He is now worth an estimated $300 million, but he retired at the age of 37 and has spent most of the past 35 years enjoying his wealth.

Rogers accumulated much of his wealth running a hedge fund with George Soros, which gained 4,200% in ten years. Soros didn’t retire and is now worth over $22 billion, but he wrote a book in the late 1980s that explained how he and Rogers ran their hedge fund. They looked at trades every day and wanted to hold positions for only a short time. They did not want 10% a year; they were after 10% or more a week.

By taking short-term gains, they achieved annual returns of 85%.

Could an individual trade like Jim Rogers and George Soros? Yes, I believe they can.

And that’s good news for investors who don’t have a time machine.  

If you compound wealth quickly, you don’t need to start investing 40 years ago to retire soon. You just need to look at the markets like Jim Rogers does and realize it is best to make money quickly and often.

This post originally appeared at Investors Alley.

Category: Dividend Basics