THE POWER OF COMPOUNDING

F.I.R.E. Lesson 3

We can achieve financial independence because of the power of compounding.

When we invest and receive a return on our investment, over time, both the investment and the return are growing. We explore making a single investment and watching it compound as well as making investments every year and watching them compound remarkably. We will also suggest how much to invest each year as a minimum so you can retire as early as you choose.

The video and the transcript are both available.

This is the third lesson in a series on F.I.R.E.

BELOW IS THE TRANSCRIPT OF THE VIDEO

TRANSCRIPT

Harland

Welcome back. My name is Harland Merriam, with Attune Investments. 

This is the third video in a series that we’re doing.  There’ll be another video next week on F.I.R.E., “Financial Independence so you can Retire Early’.  F.I.R.E. 

We’ve looked at what FIRE is and we’ve looked at three ways you can get your financial independence on FIRE.  What are we going to cover today Mike?  

Mike   

I’m Mike Jacobson and this week we are looking at compounding, what it is, the power of time and rates of return, and a suggested amount to start investing.

WHAT IS COMPOUNDING?

Harland

So we’re gonna look at those three.  The first one is  – What is compounding?  What is compounding Mike? 

Mike   

That’s when an investment’s earnings continue to earn.

Harland

Help me understand that a little bit more. What does that mean? 

Mike   

It means not only the original investment but also the earnings on that investment keep earning and growing over time.  So, for example, last week when you took money to the bank and at the end of the year they would pay you interest.  So at the end of the year, you have a little more than you started. At the end of the second year not only your initial contribution into that account earned money but also the interest you earned earned additional interest. 

Harland

Okay, that’s what compounding is.   That’s different than putting money under a mattress isn’t it Mike? 

Mike   

Like this…

Harland

Okay. Yeah. Like that. When I put my money under a mattress at the end of 1 year, 3 years, 5 years, 10 years, 30 years I’ll have my money.  $10,000 if I put it under the mattress. I’ll have that. 

Mike   

Yes, you’ll still have the $10,000 and an old mattress. There’s no compounding, no using the power of compounding. 

Harland

No compounding if you just stick it under the mattress. Well, what happens if we put it into something other than a mattress?  

But, there’s a really smart guy that spoke about compounding a while back didn’t he? 

Mike   

Yes. Albert Einstein in fact said, “Compound interest may be the most powerful force in the universe.”  

We do see compounding in many places in life.  We see it with our children. It starts as infants and you know you can just see how much more they learn. You know on a daily basis they continue to grow and it’s quite remarkable.  

We also see it in trees.  They start out very small and grow massively.

Harland

So, under a mattress, there’s no real growth, no compounding.  What happens if we do put our money somewhere else where it gets some compounding going, Mike?  Show us what that would look like. 

PUT TIME AND INTEREST RATES TO WORK 

Mike   

Okay.  Let’s say you take $10,000, invest it, and get an 8-percent return on your investment. We’re going to let that compound over 30 years.  In the first nine years, it practically doubles to almost $20,000. 

Harland

Wow! So $10,000, if I just stuck it on the mattress, still $10,000.  But $20,000 if I let it compound.

Mike   

Yes. Then, after 18 years it doubles again to about $40,000.  Remember, you started with $10,000.  Eighteen years later you now have $40,000. 

Harland

Wow! 

Mike   

And if we take it to 27 years it doubles again to $80,000. Then at 30 years, you have over $100,000.

Harland

So my $10,000 under the mattress, if I put it somewhere where it can compound, where it can get a return and that return gets a return, one $10,000 in investment can turn into $100,000. 

Mike   

Yes, that’s right. 

Harland

That’s significant!  What happens at something other than 8-percent returns here Mike?  If I were to be able to get a better return than 8 percent on that $10,000? 

Mike   

Okay, let’s take a look at that. So here we have 8-percent. We just saw it becomes $100,000 in 30 years.  Well, if we just say, for example, put it into a CD that we’re getting a 4 percent return on investment, in 30 years you have $32,000.  So, by doubling the return from 4 percent to 8 percent we tripled our ending value of our nest egg. 

Harland

I mean, that’s significant and an 8 percent return is fairly doable.  Most people will tell you 8 percent works if you’re careful.  It’s very possible.  What happens at 12-percent, Mike? 

Mike   

At 12 percent it increases quite a bit. Now you’re looking at $300,000 after 30 years.  So if we just get a little bit more of a rate of return we can triple our money in 30 years.  

Harland

That’s significant. I see 16 percent up there. 

Mike   

Yes.  Now remember, this was an initial $10,000 investment and after 30 years it would grow to $850,000.

Harland

A single $10,000 growing to $800,000 or more. Is 16 percent really possible Mike? 

Mike   

Yes.  I know people doing it consistently.

Harland

And we’ll talk about that in later episodes here of how you might get past that 8 percent and be able to really use the power of compounding quite a bit. 

But Mike, what if instead of just a single investment in year one of $10,000, if I put $10,000 in every year over those 30 years?  Would that make a difference?

MAKE REGULAR INVESTMENTS IN YOUR FUTURE

Mike   

Yes, it would, and here you have it. This assumes putting in $10,000 every year, an 8-percent return on investment for 30 years. You would have over $1.13 million after 30 years. 

Harland

If I remember right, a single investment took us to $100,000.  Now, if I just put in $10,000 every year, quite doable, it takes me to over a million dollars compounding.  Einstein was right. Compounding is quite a power in this universe in which we live here, for sure. That’s significant. But it’s something we not only see with our money as we’ve already looked at, right Mike?  We see it in nature around us. 

Mike   

Yes, we do. Just like a small seedling that can grow over time to a much larger plant, our money can grow significantly, thanks to the effect of compounding. 

START AT 10-percent OF YOUR INCOME

Harland

Thanks to the effect of compounding, we’ve looked at what compounding is, not only our initial

investment but the return on the investment, gaining an additional return year after year after year at different rates of return can be significant.

The question that comes to me now, Mike, and this may be our last point today. How much should I invest?  How much should I put in every year in order to get to where I need to get?

Mike

Well, you told us your grandmother taught you to invest 10 cents out of every dollar. 

Harland

So, 10-percent is a starting place. It was for me.  I know a lot of people talk about it that way. 

Mike   

Yeah, that would be a starting place. I kind of see it as a minimum for getting to F.I.R.E. 

Harland

Okay. And it’s possible to live on.  I’ve learned to live on 90 percent of what I make and invest the other 10 percent over time in order to get where I want to get to.  And I’ve arrived there now in my life and hopefully, other people will, too.

You have to make some adjustments.

Mike   

Sometimes you choose not to buy anything on payments.  That’s one of the traps.  As your income increases, you buy something else but if you can choose to invest at least a significant portion of that increase then you’ll make better progress toward financial freedom and F.I.R.E. 

Harland

Yeah. This goal of retiring early and getting that financial freedom. It is kind of like a snowball, Mike, isn’t it? This growth happens over time. It just keeps compounding on itself here.

THE GROWTH SNOWBALL

Mike   

Yes it is.  You know a lot of people are familiar with the “debt snowball” where you end up paying off debts.  You focus on one to pay off faster.  When that’s gone then you continue paying the amounts you were paying on the others and use all the money you’re using to pay off debts and gradually pay the others off faster and faster. That wipes out one debt at a time. 

My wife and I also discovered a “wealth snowball”.  After retiring our wealth continued to grow like a snowball, compounding as it rolls along.  Even after we started withdrawing from the nest egg we’re able to continue to grow. 

Harland

So, the snowball doesn’t stop when you retire. It kept growing and growing since your retirement as well. This is quite an added benefit here of learning how to work F.I.R.E. 

Mike   

That’s right. 

NEXT WEEK:  MILESTONES

Harland

Ten percent is a good starting place.  We recommend folks start at 10 percent. Get your returns growing along with your initial Investments. Invest something over time. Get the best return you can starting at 10 percent, just a small amount, and go with that. 

Next week where are we going to go with this Mike? 

Mike   

Next week we’ll be talking about milestones. Some of these take a while to get to, but you want to be able to celebrate them.  

Harland

Recognize and celebrate. Okay. On your way to F.I.R.E., Financial Independence to Retire Early.  Let’s pick some milestones out where you can recognize you’ve achieved it and celebrate that along the way. 

See you next week.