Time Is On Your Side: The Power of Compounding
If you’ve been a client for some time or if you’ve been paying attention to these blog posts, you are well aware that investing for the long term is key to success. The longer you have to invest, the more your money benefits from compound interest. A simple way to estimate this is with the “Rule of 72,” which gives a ballpark figure of how long it would take for an amount to double. For example, if you expected about 7% annual returns for your investment, divide 72 by 7 to get the estimate that your investment would double in about 10 years (72/7=10.286). Taking this example one step further, you will probably have about 7 of these doubling periods in your life.
You can see what a powerful driver of wealth creation that could be in theory. Someone who started investing at age 25 could have four chances for their money to double under those conditions by age 65! But what happens when real life gets in the way?
You don’t have to look too far to see that these ideal conditions don’t always match up with reality. Though it is not possible to predict future returns, with U.S. GDP averaging 1.4% over the past 10 years and the Federal Reserve still keeping overnight lending rates near zero, it may be a long time until we see economic growth that would support investment returns of 7%. In the real world, investors cannot expect 7% annual returns like clockwork. There are simply too many factors in the market that are out of investors’ control.
But what you can control is your level of savings, and how much you put away for your future financial security. Even if you cut that hypothetical 7% annual return in half, simply saving on a regular basis and allowing your money to grow has a powerful effect over time.
Of course, these examples simplify real-world situations. It’s unlikely that an investor would see annual returns of exactly 3.5% per year, or exactly 7% per year. Looking back from 1926-2015, 7.8% is the average annualized return for a 60% stock / 40% bond portfolio. So we’re using it as a rough estimate for the sake of example—but given all the unpredictable factors in the markets during that time period, from the Great Depression to dot-com bubble to the Great Recession, it’s clear that not every year will be close to the average.
However, the example above is meant to show that even if you do expect low economic growth and possibly lower-than-average investment returns in the future, there is something you can do: save! And with inflation being very low, there is every incentive to save now to benefit from additional time for your investment to compound and grow.
Another common pitfall that can derail investors from that ideal first scenario is when they dip into the investment portfolio. After all, IRAs offer penalty-free ways to withdraw funds for the purchase of a first home…and after several years of contributing to investments, a withdrawal may seem insignificant.
But that’s not always the case. On top of any penalties or taxes you might pay for withdrawals from certain accounts, early withdrawals have an even steeper penalty. You are sacrificing future compound growth with every withdrawal you make.
As you can see in the example above, it could be possible to weather one big withdrawal early on when there is plenty of time to recover (three doubling periods at 7%, if you’re keeping track). But the more frequently you make a withdrawal, or the later in life you make a big withdrawal, the less time you have to recover. On the other hand, later in life, income is typically higher and with kids out of the house, there may be fewer financial responsibilities—so it may be possible to save aggressively to make up the shortfall. The next time you’re tempted to “break the piggy bank,” keep this idea in mind. Is it worth the tradeoff?
It is crucial to understand how time relates to compound interest and investing so you can be in control of your financial future. You may not have been investing since your 20s, and you may have made some mistakes along the way. But you can be in control of your future financial security. Just think about the idea that each dollar you save today could be worth double in 10 years at 7% growth! Though we may be seeing slow growth and longer doubling periods for compound growth ahead, the same principle applies.
You Can Chart the Path to Your Goals
All of this is not meant to make you feel stressed about how long you have been investing, or how long you anticipate investing in the future. We hope these examples will empower you to look to your future financial goals and have a good understanding of what it would take to achieve them!
Please be aware that these charts represent hypothetical scenarios, and do not reflect any real market scenario. These charts are not a prediction of future returns or a record of past returns. Data calculations for these charts do not take taxes into account.
IMPORTANT DISCLOSURE INFORMATION
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Halpern Financial, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Halpern Financial, Inc.. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Halpern Financial, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Halpern Financial, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.