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.
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