1. Compounding your way to a Fortune

Drawings 1

This is the first in a series of six articles detailing information every person who wants to take control of their financial future should know.

There are two great secrets you need to know to conquer your financial future: time and compound interest. That’s it. No smoke, no mirrors, and no magic ¬– just an easy to understand mathematical concept for making your money grow and grow. Invest your money, earn a return on it, invest some more, and earn a return on that. Follow this process year after year, decade after decade, to your future.

Here is a straightforward example. Fred saves and invests $5,500 a year and earns 8% a year (long-term market averages are around 9-10%) for the next 37 years. At the end of that 37-year period, Fred will have amassed an impressive $1.2 million. And better yet, if he leaves it in and keeps investing, he will have over $1.5 million in three more years.

Save, Invest, Earn and Repeat
This is the expanded version: if you invest $5,500 at age 23, earn 8% on your investment (which is $440), you will have $5,940 at the end of the year. Leave that invested, add another $5,500, leave all of that invested, earn 8% ($915), you will end up $12,355. Continue this “save, invest, earn” pattern and this is how you will end up with your $1.2 million after 37 years, and your investment was only $203,500 ($5,500 for 37 years).
Of course, returns on investment can vary; however, if you never invest, you can never get a return.

If you are young, you have the greatest financial advantage over just about everybody else–time. You have the time to put the concept of compound interest to work for you with amazing results. No wonder Einstein called compounding “the eighth wonder of the world.”

Start Compounding Now
Current government designated retirement accounts, such as a Roth IRA, allow an investment of $5,500 a year (for younger people) to grow tax-free every year and is tax-free to withdraw after age 59 ½. Can’t spare $5,500 to invest each year? At least start somewhere. $2,000 a year, for 37 years, at 8%, yields $438,000. This beats the average of only $20,000 that most people in America have saved for retirement.
Do More

For those who want to be overachievers, you need to invest more, earn a higher rate of return, or invest for a longer time. Or do all three. Just be aware of tax consequences on yearly amounts invested over $5,500 or those not invested in government retirement accounts. There will be tax consequences, but that doesn’t mean that the power of compound interest stops working.

Your Tax-Free Money Tree

The big payoff comes when you harvest your gains. If you have accumulated $1.2 million and continue to earn 8% a year, you can actually withdraw $96,000 a year, tax-free, without disturbing your principal. It’s like having your own money tree that grows new $100 bills every year. Just go out and pick ‘em.

At this point, you have actually achieved the ultimate financial success: your money gets up in the morning and goes off to work for you for a change. Even at a more conservative, and perhaps less risky 5% return, you can withdraw $60,000 a year and enjoy every minute of it.

Don’t Wait

Start at 23, invest $5,500 a year at 8%, and you have your $1.2 million in 37 years—tax-free. Start five years later and you have to invest at least $8,300 a year to reach $1.2 million at the same age. Start ten years later, it takes at least $12,800 a year to reach that $1.2 M in 27 years. It is also important to remember, that in many cases, only $5,500 a year is eligible for favorable tax treatment. Additionally, you may be subject to interest rate return fluctuations when investing over a shorter term. These tend to flatten out for longer term investors.

How do I start?

Pick up a textbook on Personal Finance and/or take a class at the local community college. Get familiar with the properties of stocks, bonds, mutual funds, certificates of deposit and electronically traded funds (ETFs). Understand portfolio allocation, diversification, and investment risk.

Ask the wealthiest person you know how they invest and get their recommendation for an ethical financial advisor to help direct your future. Just as you would get a referral for a good dentist or a good professor, seek out recommendations for good investment advisors.

With your financial commitment (i.e. $5,500 a year) and your financial goal (i.e. $1 million) decided, schedule your appointment with a recommended investment advisor. Ask about payment structure for their services and their plan to reach your objectives.

Also ask your investment advisor about his or her investment experience and their background. It’s your money, and it’s your future. You might consider taking along a knowledgeable financial friend to the meetings.
The investment advisor who has 40 years of financial background, including many years as a small bank president, might be a better choice than the person who just quit his sales job as a cleaning supplies representative to handle your money.

Now for the next big question, “How do I save $5,500 a year?” This is a topic for the next article. Overwhelmed by student loans? Check out my website on how to attack your loans.

(Illustration by David Darchicourt)