Mr. Thrifty here. My friend asked the other day “should I wait for the impending economic downturn to increase my retirement contributions?” You can see the logic here; you’ll essentially be buying more shares for the same amount once the market tanks. What this argument fails to address is an amazing mathematical phenomenon: compound interest.
The Power of Compounding
The power of compounding is simple but powerful. Say you start with $100 in your savings account that earns you 1% annually. Simple interest, which only pays you a percentage based on the principal (i.e the $100) annually, would pay you $1 each year.
On the other hand, compound interest compounds that interest you previously received annually. And then it compounds on your new total balance the next year. And the next year. You can see how this compound effect can really add up; your money is doing the heavy lifting by compounding year after year.
Stay with me here, I’m by no means a math buff but I can do simple algebra. Here’s the formula:
Here’s a graphical representation of how simple vs compound risk really adds up:
My example assumes $10,000 invested in year 1 with 10% returns. You can see how compound interest takes off after a few years compared to only returning $1,000 a year with simple interest.
Compounding Different Asset Classes
What if we try this with different asset class? Let’s assume 0.01% for a Savings Account, 3% for Bonds, and 8% for Stocks (don’t kill me if these aren’t 100% accurate):
You can see how quickly your assets compound as you’re gaining interest, dividends, etc.
There’s a few observations we can take away from this graph. For a start, your regular savings account at your bank isn’t going to make you rich. In our example, we only ended up with an extra $151 after 15 years. Not great.
Your stocks and bonds returns are vastly different mostly due to risk – in other words, you’re accepting greater returns with your stocks due to higher risk and volatility.
The key take away we want to drive home is the compounding effect that takes place and how critical it is to get your money working for you as early as possible.
The Tortoise vs the Hare
Let’s look at this with a different example with a twist to get back to my friend asking about when to raise retirement contributions. Say I worked hard to earn a recent promotion, which comes with an impressive $5,000 raise to my salary. With this raise, I refuse to raise my annual expenses and instead invest 100% into the stock market (assuming the same 8% return from before).
However, I lose my job 5 years later due to the inevitable economic downturn my friend fears. This is his cue to begin investing. He invests the same $5,000 every year until he retires 25 years later. I never get my job back but don’t touch my original $25,000 that I invested.
Let’s see how our portfolios stack up:
Upon first glance, it’s clear that my friend was smart on waiting until the market downturn occurred. He ends up with almost double my ending balance ($395k vs $217k). But let’s dive deeper.
By entering the market earlier and by only contributing $25k total over the first 5 years, my total balance multiplied by 8.7 times. Alternatively, my friend contributed $125k over those remaining 25 years for a multiple of only 3.2x. It also takes nearly 10 years for my friend to surpass my original $25k balance.
Don’t Wait
It’s uncomfortable to not know when to invest your cash due to market volatility, but it’s clear the best time to start is now. Or better yet, yesterday or a week ago. The best part about retirement contributions such as your 401k is that those regular contribution intervals will pick up the market peaks and valleys on a monthly basis. It’s about time in the market, not timing the market.
So get out there and start compounding!
Cover image credit: Pexels.
