Alright, this is the cool part. If you’ve read this far, if you’ve followed us on the previous 11 topics of this journey, this is the best little bit. This magic sauce right here is why a 401(k) can be a wonderful retirement and investment opportunity for so many people.
The two greatest words in investing are compound interest. When Einstein was asked to describe the most important invention in human history, he responded “Compound Interest”. It’s a bold claim, but we’re buying what he’s selling.
Very simply: compound interest is the earnings on your earnings. In other words: you put a dollar in the bank and it earns interest this year. Next year, the interest you earned before also earns interest. This snowballs into something really powerful over time.
As George Clason teaches in his timeless book, “The Richest Man in Babylon”: “Wealth, like a tree, grows from a tiny seed. The first copper you save is the seed from which your tree of wealth shall grow. The sooner you plant that seed the sooner shall the tree grow. And the more faithfully you nourish and water that tree with consistent savings, the sooner may you bask in contentment beneath its shade.”
Compound Interest is Fire
Think of compound interest as being like starting a campfire. At first, it can be a lot of effort to create enough friction and spark to light even the tiniest of embers. If you’ve ever tried to start a first with two sticks, you know the frustration of all the effort you have to put forth in order to see that first spark.
Once you have the embers lit, however, the process gets easier. It takes on a life of its own and the effort it requires from you to sustain itself is much less. When the fire truly starts to set in, its tentacles spread to other branches and then those branches light others yet. The momentum of the building fire takes no effort on your part at this point; you did your work up front and then the fire took over and did the rest.
This is how financial compounding works. The first investments you make can feel like you’re not getting anything accomplished at all. The earnings seem very small when you look at the actual dollars, and this can be frustrating. Hang in there! Let the fire build. All you have to do is stay consistent with your savings and the fire will take hold; the magic of compounding interest will play itself out and you will get the payoff.
Here’s an example: let’s say Amy saved $4,000 into her 401(k) every year from ages 25 to 65. If we add up simply what she put in, ignoring any returns, it comes to $160,000. However, let’s say she invested in a typical allocation and earned an average return of 8% on her account. Because of the power of compounding interest, she’d have an account worth $1,036,226. That’s huge!
Let’s take this one step further and connect it with another principle we’ve discussed throughout these articles: let’s assume Amy makes $75,000 per year and she saves 15% of her income. In this case, she’d save $11,250 each year. If she saved that amount for the same period of time, her account would be worth $2,914,385! Even accounting for inflation, she has saved enough to fully replace her $75,000 annual income at retirement. This is the magic of both a 15% savings rate and compounding interest!
If you have any additional questions about your 401(k), retirement savings, or even about compound interest, please reach out to any of the Invst advisors for help on your individual situation.