Compounding & Rule of 72 - How Rate of Return & Time Impact Your Account Balance

Hey, what's up everyone and welcome to the School of Personal Finance. In this week's video, I'm going to bring you back to a video that I posted just over two years ago. And I think it was one of my best videos and it's an important topic, so I wanted to show it again. So the topics that we cover in this video are simple versus compounding interest, the rule of 72, how important it is, and examples of what difference it makes when you start saving early, and also the importance of the rate of return that you could earn on your investments and the impact that it has over a long period of time. I also walk you through some examples of what it will take to get to having a million dollars in your investment accounts and the different amounts that you have to save at different rates of return throughout the years. So I hope that you find this one helpful. Compound interest, it is such an important topic. It's not taught in schools. People just don't get it. They don't understand the power of it and how time and rate of return, they make all the difference in the world. So I hope that you get value out of this video. All right, let's get to it. All right, so a few quick things before we start. Number one, come follow me on LinkedIn. I will put a link in the description down below. Number two, come enroll in the School of Personal Finance. Take the course Master Your Family's Finances in 30 Days. In addition to the pre-recorded courses that I'm continually adding in the School of Personal Finance, I'm also going to be having live courses that I will teach over Zoom. In addition to that, I'm also going to have live office hours where you can come in and ask me anything. I'm also going to be having webinars where you can come join. We'll dive a little bit deeper on specific topics and also do monthly updates about the market, about timely things going on like IRA contributions, tax deadlines, things like that to just keep you in the loop of everything. So I'm creating an entire educational center to help you become great with money. There's just a one-time enrollment fee for lifetime access. So come check it out. So now when I went back and watched this video, a couple things jumped out at me that are very different now. I mean, first of all, the market has been so volatile. We've been through a crazy time. So dollar cost averaging through your retirement plans, all of that, it is going to help you to get these averages, these rates of returns because now that we're down lower, hopefully you're adding money to all of your accounts. And as the market starts to rebound, those low contributions that you're making now, they will hopefully appreciate well over time because we're down as I'm making this video like 25% in the S&P 500 year to date. So it's been pretty painful. Another number that I referenced in this video is inflation, where I talk about a 2.5% long-term inflation rate, which is historically what it has been. Right now we're living in like an 8.5% inflation rate. And that's the formal, the CPI number. But in reality, it feels like we're living in 20% inflationary times with the price of gas over $5 a gallon and just everything completely through the roof. So if inflation doesn't come down, then that is really going to put a kink in all of our retirement plans going forward. But hopefully we are near peak inflation or at peak inflation and those numbers will start to come down towards the historical averages. All right. I hope that you find this video helpful. The best way to start is if we compare what simple interest is compared to compound interest. Now compound interest, all it really means, it's when you earn interest on your interest. Let's look at an example and we'll use simple interest first. So now simple interest is when you earn interest only on your initial investment. It doesn't compound. So for example, if you put $10,000 into an investment, let's pretend that it's 1980 and that you could put it in a bank CD and earn 8% for a 10-year CD. So if you do that, if you invest $10,000, you will earn $800 per year on that CD. So at the end of the 10 years, you would have earned $8,000 of interest. So you would have a total $10,000 investment, $8,000 interest. You would have a total of $18,000. During that time, your interest did not earn interest. Now when we compare that to compounding interest, you invest the 10,000. At the end of the first year, you have the same amount. You have $10,800. You receive 8% interest for that year on your $10,000. But now in year two, you're going to receive 8% on your $10,800 amount. So that $800 interest in the first year, that now gains interest. So now at the end of year two, you would have $11,664 compared to the $11,600 that you would have had in the simple interest example. And then at the end of year three, you would have $12,597 with the compounding compared to $12,400 that you would have with the simple interest. And then that would go on for the 10 years. At the end of 10 years with the compounding, you would have $21,589. So that's $3,589 more than you had in the simple interest example. Now a big point you need to remember here is that in order for compounding to work, you have to reinvest the interest that you receive. So if this was a dividend stock, you would have to reinvest the dividend in order for it to compound. If you take the income, like in this CD example, if you took that $800 out at the end of each year and spent it, then obviously it's not going to compound because now you took it out of the account. So it can't earn interest anymore because it's gone. So in order for compounding to take effect and to work, you have to reinvest the interest or the dividends that you receive on the investment. So if you're thinking to yourself after that example, like, yeah, it's cool, I'd have an extra $3,500 after 10 years, but it's not going to change my life. You'd be right. So for compounding interest really to have a magical effect, there are two main components. There's time and there's the interest rate, the rate of return that you could earn. So unfortunately, compound interest, it doesn't work for everybody. Not everybody gets wealthy using it or else we'd all be rich. So the reasons that it doesn't work for everybody is because the main components, they're not that easy to achieve. So like the first one is you have to have money to invest. You have to have money to save. You have to have extra money that you're saving for long periods of time without tapping into it, without spending it. That's hard for most people, right? As you start seeing it accumulate and things happen in life, you're like, oh, well, I have this pile of money that I've been saving. Let me use some of it to alleviate whatever stress I have going on in my life. So that prevents it from really compounding. The other thing is the rate of return. People invest too conservatively. They're nervous. They don't understand how the stock market works, how growth investments work, and they go to safety. But if you invest too conservatively over a long period of time, it really cripples the growth in the account. Like yes, if you're investing for something that's five years out or three years out and you need the money to be there, then you have to invest it conservatively. But when you're investing for retirement, if it's 30 years down the road, then you need to be more aggressive with your investments so you could achieve that higher rate of return. So to dig in a little deeper here, I'm going to explain to you what the rule of 72 is. So if you take 72 and you divide it by the interest rate that you're receiving on an investment or on a savings account or whatever it is, then that shows you how many years it will take before your investment will double. So for example, if you have a 10% rate of return on an investment, it'll take 7.2 years for that investment to double. If you have an 8% rate of return on an investment, it'll take 9 years for that investment to double. If you have a 3% rate of return on an investment, it'll take 24 years for it to double. So that is the effect of compounding. That just shows you how big of a difference it could make depending on the rate of return that you get on how your money is invested. And when we think of rate of returns and what's realistic and what's not realistic, I mean earning 10% is difficult. 8% is a realistic rate of return if you're invested aggressively. We can only use history as a guide. We don't know what's going to happen going forward. But if we look back at the stock market since like 1960, on average it's returned around 10%. And that would be if you were invested in just like the S&P 500 index fund. But you have to make sure that your costs are very low so that doesn't eat into your returns. But an 8% rate of return is realistic. The hard part is actually just doing it and letting it be and not messing with it through those 40 years. Now you always hear everybody say, I wish I started earlier. And I mean, I fall into that camp. Everybody says that. I wish I started investing earlier. I wish I started saving earlier. And it's for good reason. I mean, let's look at a quick example for somebody who starts at age 20 compared to somebody who starts at age 35. All right. So let's say our 20 year old, we'll call him Tommy. Let's say that he's contributing $500 a month into his retirement account. All right. Maybe that's a combination of his money going in plus an employer match. I mean, $500 is a lot of money for a 20 year old. Let's say he's making good money. He wants to save for retirement. He's able to do it right now. So he's putting in $250 and let's say the employer's matching $250. So he has $500 a month going in and let's say he does that for 20 years. He doesn't increase it. He keeps it at $500 a month. That happens over a 20 year period. All right. And then at the end of 20 years, he needs to stop. Let's say he loses his job or he stops working or he has a pay cut or maybe has a bunch of kids at this point and he just can't afford to do it anymore. So he actually stops contributing and he doesn't contribute anymore until he retires at age 67. So age 67, he would actually have, if he earned an 8% rate of return, he would have $2,535,496 in that account. That's a lot of money. All he did was save from age 20 to age 40. So he invested a total of $120,000 over that 20 year period. So now let's compare that to our 35 year old. Let's call her Faith. And Faith, she hasn't contributed any money into anything up until this point. She's 35 years old and she feels like she's behind. So she's actually going to put in $1,000 a month into her retirement account or whatever account we want to say that it is. So she's doing $1,000 a month and she continues to do that for 32 years all the way up until retirement until age 67. All right. So from age 35 to age 67, she's putting in $1,000 a month. At retirement at age 67, she's going to have $1,773,958 in her retirement account at age 67. So over the course of those 32 years, she would have put in $384,000. So that is actually $264,000 more than Tommy had put in. And guess what? She has $761,000 less than Tommy does at age 67. That is powerful right there. It's just a very good example of how starting early makes a huge difference. All right. So now let's look at another quick example. In this example, we're going to have two 25 year olds. We'll call them Ryan and Olivia. And the big difference in this scenario is going to be the rate of return that they could receive. So they're both going to invest the same amounts. They're both going to invest $300 a month into their retirement account, and they're going to do it for 40 years. But now Ryan, he's risk averse. He doesn't want to invest in the stock market, in growth stocks. He wants to be in a much more secure and stable portfolio. He doesn't like the volatility, the ups and downs of the market. So he's able to generate a 3% rate of return over that 40 year period. Where compared to Olivia, Olivia understands the stock market, how over the long term, the averages work in her favor, how history has shown that the stock market could return somewhere between 8% and 10% if you're invested for growth and for the long term. So she does that, and she's able to generate an 8% return over that 40 year period. Let's see what the difference is in the amount of money that they have at the end of that 40 years. So now Ryan, with his 3% rate of return, he's going to have a total at the end of 40 years of $277,817. So not too bad. Over his 40 year period, putting $300 a month into the account, that's what he would end up with. Now Olivia, at 8% average return year in, year out over the 40 year period, she would end up with $1,047,302. That's a pretty big difference. Now obviously, with the stock market, there's a lot of risk. You don't know what's going to happen, so you have to be able to stomach the ups and the downs. There will be years where you might be down 30%, and it feels terrible. We just went through March to April, the market dropped basically 30% with the coronavirus like that. So you just don't know what's going to happen. And when it does happen, it feels like the end of the world, and it's scary. But if you're investing for the long term, things usually grow over time. History is our guide. So to be able to stomach it, and to go forward, and to add money when it goes down, that's how you get these averages of 8% or so over the long run. And again, full disclosure, I don't know your situation. I'm not making any kind of recommendations whatsoever. How you should invest, what you should invest in, these are all just general terms for educational and entertainment, hopefully entertaining purposes. All right, so now let's run through some quick numbers. I'll show you what it will take for you to get to a million bucks, if that's what you want to get to. Now obviously, 30 years from now, a million bucks, it's really going to be like 500,000 bucks with inflation and everything. But let's show you some quick numbers. So let's say you have nothing saved right now, and you want to get to a million bucks 10 years from now. What would it take? Let's again use the market averages. Let's say 8% is a realistic number that you could earn on your investment. If that was the case, you would need to save $5,466 a month in order to get to a million dollars 10 years from now. Pretty tough to do. So same scenario, but now let's make the assumption that you already have $200,000 saved. So maybe you're 40 years old, and you have 200 grand in your 401k account, and you want to get to a million by the time you're 50 years old. If that's the case, then you would need to be investing about $3,000 a month, $3,040 a month at 8% rate of return in order to get to a million bucks. Still pretty difficult. Let's say you're just starting, and you have 30 years to go before you want to hit a million bucks. 8% rate of return, you'd have to save $671 a month over the next 30 years in order to hit that million dollar mark. Now obviously, 30 years from now, a million dollars, it's not going to be a million dollars. So inflation is going to make it feel like much less when that time comes, and we could actually get a very good idea of it using the rule of 72. So if we say inflation averages around 2.5% per year, use the rule of 72, and we would see that about 30 years is what it would take for that to double, meaning that if you need a million dollars for retirement, and you're not retiring for 30 years, you're really going to need $2 million in order to have the buying power that a million dollars has today. So if you're 30 years away, whatever you feel like in today's dollars you need to retire, you really need about double that just to put a cherry on top of this whole thing. So now as you can probably tell, I enjoy running these numbers. I've been doing this for years where I just play with numbers and see if I save this, what will I have? How does the rate of return affect it? It's very helpful, and it kind of keeps you on track because you can see how you're progressing, how you're doing, and you can dream up some nice scenarios as you get older in life and how much money you could actually accumulate. It keeps you motivated. This has been fun. I hope you got some value out of this. I will see everybody again in the next video. Make sure to subscribe and hit that like button. Please share this video with as many people as you can, and I'll see you again next week. Thanks a lot. Bye.