Mellody Hobson talks about the power of compounding on today’s “Money Mondays” segment.
I’m sure TJMS listeners know about the power of compounding. It’s how you make money on investments over time—where you earn interest on your interest. When it comes to achieving long-term financial goals like a secure retirement, compounding is the key. There’s even a popular urban legend (that may or may not be true) that Einstein called compounding, “the most powerful force in the universe.”
Think about it this way: If you had a penny and doubled it every day for a week, you’d have 64 cents. But if you took that same penny and doubled it every day for a month, you’d have over ten million dollars.
I can show you the math. It starts with one penny. You don’t need to be Einstein to realize that harnessing the power of compounding is the way to earn money in the stock market.
Okay, so what’s the best way to harness that power?
First of all, compounding is about getting started early and investing regularly. All too often, people try to time the market. And now, with the stock market at record levels, people may be tempted to cash out in the effort to “sell high.” Don’t do it.
The greatest investment minds have proved over and over that timing the market doesn’t work. I don’t try to time the market, and I know a thing or two about investing. Warren Buffett doesn’t try to time the market, and he’s arguably the most respected (and wealthiest) investor of all time. So it’s just plain crazy when the average investor thinks he or she can time the market with any measure of success. What pays off is time in the market, not timing the market.
The average investor can take advantage of compounding by dollar cost averaging—investing the same amount of money at a regular schedule, regardless of the share price. Let me give you an example about how this works.
Let’s say a 20-year-old woman opens an IRA and puts in $5,000. She never makes any additional contributions and doesn’t touch the money until she’s 65, at which point, assuming an 8% annual return, she’ll have $160,000. Take that very same one time investment but make it a 40-year-old woman and she’ll only have $34,000—In this case, two decades equals $126,000. Time is the critical factor here.
But let’s go one step further and say our 20-year-old socks away $5,000 every year—dollar-cost averaging for the next 45 years until her retirement? She’ll be sitting pretty with $2 million. (Our 40-year-old would have just $400,000.)
So what’s the holdup?
Not surprisingly, most 20-year-olds don’t spend time thinking about retirement. It’s the older set that worries. In a survey released last month, The Employee Benefit Research Institute found that 28 percent of respondents had no confidence at all in affording a comfortable retirement. That’s the highest number ever recorded since the annual survey began 23 years ago.
People aren’t confident because they know they’re not saving enough each month. Part of that, certainly, is that Americans are struggling just to keep up with day-to-day expenses and the rising cost of living. But I think there’s something else at play: Fear. BlackRock did a survey last fall that found more investors spend time planning vacations than planning for their retirements. Vacations! Planning for retirement isn’t a priority because it’s scary to imagine we may not have enough—and it’s easy to continue to bury our heads in the sand and draft our itinerary for Florida.
This ties into what I call the stinky refrigerator problem. Instead of biting the bullet and taking the time to sit down and look carefully at our financial goals and how we might meet them, we take the time to see what’s to blame for that smell in the fridge!
Retirement is an easy topic to put off when we’re constantly sidetracked by more immediate issues. People spend a TON of time on home improvement projects, and that makes sense. It’s where you live and there’s an immediate uptick in your quality of life when you fix something around the house. But believe me, you’re going to have a MUCH stinkier mess on your hands if you don’t start saving NOW for retirement.