The Critical First Step Toward Financial Independence
One of the most significant “Ah hah” moments for me was learning about the importance of time as it relates to investing, or more specifically, compound interest.
Twenty years ago when I was 23, I attended a Dave Ramsey live event where he went through his financial peace routine.
Naturally, he addressed investing and made a point about the importance of getting started early using two fictional characters named Art and Ben.
In this hypothetical scenario, starting at age 19 Ben invests $2,000 each year for eight years, then never contributes another penny to the account. He just lets compounding interest take over and do the rest.
Art, on the other hand, waits until he’s 27 to begin saving, but he saves $2,000 each year for the rest of his life.
So, between ages 19 and 65, Ben saves $16,000 (8 years) while Art saves $78,000 (39 years).
In the example that Dave Ramsey gave, each of these guys earned an average annual interest rate of 12% (which is a bit unrealistic, but I’ll come back to that in a minute).
At the end of their 65th year, Ben has $2,288,997 while Art only has $1,532,183.
So, even though Art invests $52,000 more in his life, he never catches up to Ben.
Furthermore, in this example, Art won’t ever catch up to Ben because the annual return on Ben’s portfolio is outpacing the $2,000 Art is investing annually.
But About that Rate of Return
To me, this was a great example of the power of compounding interest, but unfortunately, the assumed rate of return can be a bit distracting.
For years, Dave Ramsey has consistently argued that a 12% average rate of return is easy to find with the right mix of mutual funds.
He also never specifically shares which mutual funds he’s speaking of, just generally recommends four investment classes for investors to look for.
In my opinion, it isn’t very realistic to expect an average rate of return of 12% throughout your investing life.
For one thing, even if you were 100% invested in a total US stock market fund, based on historical returns you should expect something closer to 8.35%, not 12%.
An S&P 500 index would do much better at 10.67% historically, but this is still well short of 12%.
Also, your portfolio is probably going to shift from a more aggressive to a more conservative strategy as you age. This means lower volatility, but it also means lower average returns putting you even further away from 12%.
The bottom line is that 12% is a bit on the aggressive side.
At best, I would assume a 10% rate of return and 8% is even more likely, but even that is before inflation is taken into account.
In the example of Art and Ben, if they both earned a 9% average rate of return they would reach age 65 with almost the same amount in their portfolios, though even then Art won’t catch Ben until they turn 83!
Sadly, a lot of people get hung up on the assumed rate of return in this example which causes them to miss the ultimate point.
The Power of Compounding
Even if Art and Ben achieved a 9% rate of return the fact that Ben was able to do that with barely more than 1/5th of the money should blow your mind or at least cause an internal light bulb or two to flicker.
Framing this another way, the eight-year head start Ben got took 39 years for Art to make up!
Is there anything you’d rather spend 39 years working to achieve than 8?
Me either.
In another post I wrote a couple of years ago, I looked into the opportunity cost of a dollar over different ranges of time.
He is that data in a table:
Basically, this illustrates that every dollar you spend today has the opportunity to be $7.60 in 20 years, $57.70 in 40 years, and $159.04 in 50 years!
This chart does assume an annual rate of return equal to the historical average of the S&P500 which is 10.67%.
By thinking about the money we spend in terms of what it could be, we have the tendency to value it more.
It’s a bit more natural for us to do this with hindsight than foresight.
That’s why we have a harder time getting rid of some items the older they are because there’s been at least some investment of time in preserving the item up to that point.
We hate to waste it, don’t we?
Well, in the interest of foresight, here is a graph illustrating the exponential power of compounding interest on the same dollars in the table above.
It hits a little differently when you see it this way because the graph so clearly shows how beneficial patience can be.
Then again, it also shows us that there are a lot of years between now and the exciting days where the interest feeds itself like a fire that’s so hot it seems impossible to bring under control.
Which brings me to my final point.
It’s Worth Your Time
If it’s not too personal, I’d like to open up a small window into my soul.
I…hate…wasted…time.
As I was growing up, I thought it was strange when people would say that time was a more precious resource than money.
Because I was young and I had a lot of time and no money, I valued money but thought little of my time. It’s kind of amazing how things change.
If you happen to be middle-aged, as I am, and have kids, as I do, you can probably empathize, though neither is a requirement for you to understand what I’m talking about.
Well, just as time is precious to us professionally, socially, and even culturally, time is critical to our success financially.
This example Dave Ramsey provided was life-changing for me. I don’t necessarily recommend ardent submission to every detail of his baby steps, but it would be dishonest if I didn’t credit him with altering the path of my life that night.
Why?
Because when this was presented to me, my net worth was below zero. I was just happy to have a job to keep me fed until my late 60s. To me, wealth was for trust fund babies and business tycoons.
This was the first time it had ever occurred to me that I had an opportunity to build real, significant wealth.
As I mentioned earlier, I was 23 when I first saw this example.
This meant the ship had sailed for being Ben, but I could still beat Art. And since Art cleared $1.5 million before 65, anything better than that was okay with me.
Then, later on in the show, as I was still thinking about Ben and Art instead of listening to Dave, it occurred to me that I didn’t have to only contribute $2,000 each year if I was capable of contributing more.
If $2,000 per year could get me to $1.5 million, then $4,000 each year would put me over $3 million!
I was sold. I had already been saving and investing some, but it became a much higher priority that night.
I’m writing this post in the hope that it will motivate someone out there to do the same thing. Change your trajectory. It is within your control!
So, let me encourage you to make saving and investing a priority if you haven’t already done so. Sell something if you need to. Get another job or start a side gig if that’s what it takes.
Whatever you do, do it now. You must make saving and investing a priority.
And if you’re up in years as you read this and you think it’s too late for you, let me assure you that waiting until later is not going to make it any easier.
You’ll just be older with less time and the same amount of money. That’s no bueno, my friend.
Wrap Up
If you’re not sure where to start, we have loads of content on the website and YouTube channel to get you going.
If you truly don’t know where to start, may I suggest that you check out our Next Dollar Roadmap? It’s a cradle-to-grave guide for building financial independence.
Thanks for reading.
