Sometimes the way to learn something is simply to review our mistakes or those of others. Then learn from them. The plight of a friend of mine—in his 50s and with a good job but no retirement savings—recently illustrated for me why millions of people go through life and never seem to do anything about their finances. How does this happen to otherwise bright people?
On personal finance, they figure good fortune will at some point find them. Some think that they’ll win the lottery or maybe an unknown relative will die and leave them a bundle. I suppose those kinds of things can happen (mostly likely in movies or on the tube). I also suppose that Denise Richards or Cindy Crawford could be calling sometime soon and asking me for a date. However, I wouldn’t count on it.
The irony is that these people often are accomplished professionals. They have done well. So many of them seem to think financial knowledge is something they don’t need because they have good incomes and lots of fat years in front of them. However, as youth fades and they head deep into middle age, they find themselves confronted by a financial crisis. They don’t know how they will live comfortably when prime earning years are over. And for most of us, living in a highly competitive world, that will happen sooner than expected.
I think overcoming the problem of finances is similar to so many others we face in life: inertia. In so many seemingly difficult issues, it is just too hard to get started so many people never do.
The first step always seems impossibly difficult. Yet, as in so many things in life, there’s a surprising fact: When we actually begin on a chore, we often find it’s usually not as hard as we believed. Showing up, as Woody Allen said, is more than half the problem. So, too, is taking the first steps on the road to financial independence.
If the average person just began to save today for tomorrow on a systematic basis, if he or she just began with modest amounts in early or middle age and if he or she just put an automatic saving plan in place, he or she would find something remarkable: One can get used to saving and investing on a regular basis. One can do it after a while without even thinking about it. It can actually become relatively painless.
Indeed, it can be accomplished by setting up automatic savings and investment deductions from your paycheck or your checking account. After a while, one doesn’t even think about it, except when one receives quarterly or monthly statements and starts to realize something wonderful: One is slowly moving toward financial independence.
Time starts working for you—the magic of compounding is building balances for you instead of against you as when you pay debts that compound at high rates every month. The latter is the haunting feeling, as the years go by, that you are missing opportunities to achieve financial goals as debt eats up money that could have been used for investment opportunities. And the best financial goal in my opinion, is the independence that comes from knowing that you have enough saved or invested. It means, for example, that you no longer have to work in an unpleasant job, or even in one that may be pleasant today, but probably won’t be if your boss is fired or moves on or your company goes through bad times.
The Power of Compounding
Compounding is the key to the accomplishment of almost any financial goal. Starting it and continuing it for as long as possible is the best chance most of us have to achieve a financial goal. Why is it so important? Why is it even more important, in some cases, than the long-term rate of return you earn?
It is because compounding is the principle of money throwing off money; of your initial dividends generating secondary and tertiary dividends. It’s what people with little or no investments mean when they complain that the “rich get richer.” Here’s one way they do it.
Say you have an investment of $1,000 and you earn 10 percent in year one. At the end of the year you have $1,010. But, if you again earn 10 percent in the second year, then you have, not $1,020, but $1,021.
Where did the extra dollar come from? Compounding. Sure, it’s only a dollar extra. But, if one continues the process, and increases the amounts, the amount of compounding grows. The patient investor is rewarded for letting his or her money grow; for letting the compounding process take place over long periods.
Let’s take two investors. Investor Liam invests relatively small amounts every month—say $200—and only earns nine percent a year. But he maximizes the compounding process because he does it over 40 years, ultimately putting in $96,000.
Gregorio Needs Help
Now let’s look at Gregorio. He earns significantly more on his investments than Liam, some 12 percent a year. He invests $500 a month, but only does so over 20 years. And he ends up investing $120,000 in total.
Who comes out with more? Liam or Gregorio?
Remember, Gregorio invested almost $25,000 more and earned a much better rate of return, 12 percent versus nine. However, it’s not even close. Liam wins. $943,000 vs. $500,000 for Gregorio.
Liam wins because he let the compounding effect take place for 20 years longer. That was a much bigger factor in creating wealth than Gregorio’s higher rate of return and his investing $25,000 more.
If only pobre Gregorio had given more importance to the power of compounding he would have done much better. Indeed, if he would have compounded for five more years, he would have slightly beaten Liam ($948,000 versus $943,000). And if Gregorio had invested for five more years—say 30—his numbers would have virtually doubled. Santa Maria! He would have had $1,764,000.
In this example, not taking full advantage of the power of compounding hurt Gregorio. And not overcoming your inertia will hurt you if you delay a systematic savings and investing plan. The sooner you start, the sooner you put an automatic pilot plan in effect, the better.
Overcome inertia. Embrace the power of compounding. Now you can start to think about a future of financial independence (And for more on that topic. Please see this column ( http://gregorybresiger.com/ten-steps-on-the-road-to-financial-independence-how-do-i-get-started/).
Why? You have a powerful force behind you. The mathematics of compounding are on your side.