My Favorite Recipe

Let me tell you what I made for dinner tonight - I pan seared some wild salmon (farm raised? rookie please) seasoned with simple salt & pepper, tossed around with green onion, finished off with fresh squeezed lemon juice. Baked sticks of asparagus in the oven at 425 degrees, coated with olive oil, for 15 minutes. Paired those with some sweet potatoes...that's what I call victory on a plate.

That's not my favorite combination though. What takes the cake is a mix of principle, time, and consistent re-investment. This lethal recipe unleashes a mathematical concept that really floats my boat. It's something that has way more real life meaning for most than knowing how to integrate and take the derivative, or remembering which president was the first to get his PhD (Woodrow Wilson).

What is compounding all about? Basically, compounding is the process by which money you've made on your original investment starts making money for you. The best way to capture this is with an example and picture. To demonstrate, let me introduce to you Sally and Pedro. Both just graduated college 2010, working at the same engineering firm, both 25 years old. Sally growing up had dreams about the powers of compounding, and decided to start putting $10,000 a year towards her general portfolio. Pedro on the other hand was busy trying too hard to pick up chicks, and only saved $1,000 for his first 15 years working...until Sally informed him he was going for ones way out of his league. Then once he settled down, Pedro picked up his investing and started to put away $10,000/yr instead.

After doing simple back of the envelope calculations and assuming a 7% average return compounded annually, we get the following totals at :

age 54, Sally has hit a cool $1MM, while Pedro lags behind at $340k
age 65, Sally has retired at $2.3MM, while Pedro realizes it's too late to enter the adult films industry and wonders what went wrong (where are his Napoleon Dynamite movie royalties?). While he has an $890k portfolio, he lacks the buying power...a million wasn't what it once was in 2010, as it is in 2050

Just imagine if Sally's portfolio was a basket of dividend stocks, giving a 4% yield. Even if the market was having a bad year and netted a 0% return for the year, that still means Sally either would receive ~$92,000/yr just from her dividends, or $7,600/month, in cash payment or to re-invest directly back to those respective stocks. Dividends to be discussed in a future post.

What else do we notice here in the chart? Why Sally's curve is running away from Pedro's faster than residents leaving the city of Detroit. Sally's compounded earnings are gaining her even more returns. Is that even fair? I bet she cheats at Monopoly.

Compounding and investing is not as simple as the example above, but the point should come across loud and clear. If you start investing early and often, you will reap the benefits later in life. In life and in investing, there are always tradeoffs that must be made, and a balance of how much to save and how much to spend here and now. This doesn't mean you have to be a Sally to be successful with your savings plan...many variables go into your goals and how you define success. That's a topic for another week. Anyway, that's why my favorite phrase is 'Why not make money work for you'. On deck for next time...how your personal goals should relate to your investment strategy.

What we missed when we were young..

I missed the school bus to my last day of 2nd grade. Didn't get my yearbook signed. Fortunately, Emma Watson didn't go to my elementary school.

There are plenty of learning opportunities I wish I had more of before entering the real world. I won't be selfish for one minute here (only child problems...I was never good at sharing), I mean for the general public. Going through high school, you had your typical required classes, and more flexibility Junior/Senior year. One theme I don't recall being around? Money Management. I mean, what better way of teaching kids real life lessons and tangible skills than that? You could make it as interactive as you'd like, and money talks, even freshmen know that. It's not even like you have to put yield curve or Dow Theory in the curriculum...just ensure basics are covered, like personal savings/budgets, how to build credit, and different investment options. Introduce how borrowing works, and demonstrate simple mechanisms of how to make money work for you. Teach the trade-offs between instant gratification vs. savings/interest. I'll take tips on how to start up a lawn mowing operation rather than an Astronomy lecture any day (will the Big Dipper provide me positive cash flow?). I need the grammar police to check that punctuation.

Next, there needs to be required seminars in college on this same matter. This is where we can even step it up a notch. Make this a requirement 101, half a credit, include some simulations and team games/events. Teach the basics of personal finance, assets vs. liabilities, and even post-graduation loan projections (this however might lead to less Art History majors...what can I say, collateral damage). Run through an owning a lemonade stand simulation, play a paper investing game. Talk about the different investment options, talk about owning real estate. Make those attending the seminar engaged and wanting to learn more. The goal is not to increase the graduation classes of the finance department, but to, at an early age, plant the seed of the importance of properly managing money (no one wants to be the next Mike Tyson). Instill the desire to learn more about the financial issues everyone will one day encounter :

buy or rent?
traditional or roth IRA?
how do I build credit?
what's a bubble?
when can I retire?
should I pay a higher monthly rate for my car loan, or invest more instead? well...what if I told you that your 3% interest rate on the car payments was lower than the 7% average annual growth rate of the S&P 500?

Anyway, my ramblings above represent my feelings on an unfortunate gap in the education system that could be easily solved. Maybe if I knew more when I was younger, I would have asked for some Apple stock instead of a new bike. That thing only got me scars. I don't want to run into any more college graduates complaining about their student loan payments. Should have paid more attention in Money Management 101, chief (your English degree turned post graduate job of blogging about managing money at 20k a year isn't going to cut it). Next blog post up...the power of compounding!