CONGRATULATIONS reader of this blog, you are today’s hypothetical thought exercise winner! Benny, tell them what they’ve won! As today’s lucky winner you have the choice between two great prizes. You can either take ONE MILLION Dollars cash OR you may decide to have your prize paid out as one penny doubling every day for 30 days ($0.01 today, $0.02 tomorrow, $0.04 the day after etc.) Which prize do you choose?
Okay, let me try to guess what’s going through your head right now. Your brain is thinking that if I’m framing something so absurd as comparing $1,000,000.00 to $0.01 that there must be a catch. But at the same time, in what world could a penny doubling every day for 30 days possibly be better than taking $1 Million dollars, right? Well, if you’re like most people who are asked this hypothetical, you decide to take the one million dollars. But as hard as it is to fathom, the penny is the better choice. It’s actually 10 times better. Here’s the math:
Day 1 = $0.01
Day 2 = $0.02
Day 3 = $0.04
…
Day 27 = $1,342,177.28
Day 29 = $5,368,709.12
Day 30 = $10,737,418.24
Crazy right!? Here is another fun one. Cliché legend says there was once a brave and wise Knight who saved an ancient king from certain death. The King was so grateful to the knight that he offered to pay whatever he wanted. The knight, wise as he was, said to the king, “Great King, I only ask that you take out your chessboard and place one grain of rice on the first square for me to take today. Then tomorrow place two grains on the second space and the day after place 4 grains on the 3rd space. I will come back every day until you have placed grains on the final 64th square, at that time my reward will be complete.” The King finding the offer odd but believing the reward to be far less than he was prepared to pay accepted the Knights offer and told his servants to ensure the Knight’s request was completed. To make a long story short the King was screwed, like really, really screwed, like he was going to have to come up with more grains of rice than had ever been cultivated, screwed. On the 64th day, the King must pay the Knight eighteen quintillion, four hundred forty-six quadrillion, seven hundred forty-four trillion, seventy-three billion, seven hundred nine million, five hundred fifty-one thousand, six hundred and fifteen, grains of rice. Whoo! Talk about a lifetime supply. Not sure where you actually store 1.4 metric tons of rice but that seems like a good problem for the Knight to have.
What’s the point of these different examples? Compound interest is an incredible thing. The growth is exponential and the sooner you start to invest the better. Let’s look at some real-world examples. The S&P 500 has averaged over a 10% annual return since 1926. When you include dividends that return is closer to 12%. Accounting for 2-3% inflation you can assume an average 9% annual return on a full stock portfolio. The law of 72 tells us that this 9% return means that your money will double roughly every 8 years.
With that out of the way it’s time to introduce Little Timmy, Millennial Mike, and Boomer Bob. All three of our subjects just opened a Roth IRA for retirement and deposited $6K. They plan on doing this every year for the next 8 years. The difference is their ages. Little Timmy is only 18, Millennial Mike is 34, and Boomer Bob is 50. Let’s assume that none of these men ever deposited another cent into their Roth IRA after the 8th year ($48K total). Let’s fast forward to each subject reaching the age of 66 to see if they are ready to retire.
Little Timmy, after 48 years of interest, has an account balance of $2.5 Million, enough to live off six figures a year in retirement using the 4% safe withdrawal rate. Even though Millennial Mike was still in his 30s when he started investing, at the age of 66 his account is ¼ that of Timmy’s. Mike has a balance of $618K, this is probably enough to retire but it is going to need to be a lean retirement. As for Boomer Bob, well, he’s in trouble. Bob has only $155,742.68 in his account. Not nearly enough to retire, but still a lot better than just putting that $48K into a taxable savings account.
So, what’s the lesson here? Save and invest early! let the power of compound interest go to work for you. The best thing you can do for yourself is to put whatever money you can in a tax advantaged account when you are young. Every dollar saved in your 20s is likely to grow 30x by your 60s. By not starting early you’re not just kicking the can down the road. You’re limiting the power of compound interest and forcing your future self to save a much larger portion of income to make up for not putting anything aside in your 20s.
For the finale I’ll leave you with a late-night infomercial to bring it home. “Don’t wait, start now, invest in yourself today! For just $16 a day, YOU can set yourself up for retirement. No catch or gimmicks just let the power of compound interest work its magic.”