The Secret to Investing (Core Post No 5)
What can Wheel of Fortune and The Price is Right teach us about the secret to growing wealth over time?
In this post, we’re going to explore the secret to investing. It’s an incredibly important concept—even life changing—but, on the surface, it can seem a bit boring. So, let’s turn it into a game show.
With a nod toward Wheel of Fortune, can you complete the puzzle? We’ve spotted you a few letters.
Before we reveal the answer, let us ask another question.
If you plan to retire in 20 years, how many years do you have to invest?
The most common answer to this question is 20 years. But that’s not right.
The correct answer depends on how long you live during retirement. If it’s 30 years, then the answer is you’ll be investing for 50 years, at least with some of your money.
The point is: you don’t invest to retirement, you invest through retirement.
The reason this is relevant comes back to the answer to our puzzle. The key to growing wealth through investing is: COMPOUNDING.
Now, you’ve very likely heard of compounding, but there’s a good chance you may not fully appreciate how powerful it is.
It’s so powerful that Albert Einstein called compounding the 8th wonder of the world. Warren Buffett said he discovered compounding at age 10 and that it’s the secret to his massive wealth.
We have found that the best way to appreciate compounding is to experience it. It takes too long in real time, so we’ll steal an idea from another classic game show, The Price is Right.
We want to explore what happens if you make a one-time investment of $10,000. You never add another penny, but you do let the money accumulate—or compound—over time. We’re going to assume your money grows at 10% per year.
This 10% compounding rate is critical, by the way, and we’ll touch on it again in a moment. Suffice it to say that this is doable in the real world and we’ll explore how in more detail in future posts.
We want to know what this $10,000 investment will be worth after 40 years of compounding. But we’re going to stop and check things along the way.
The Value in 10 Years
We’ll do the first one for you. If you invest $10,000 and earn 10%, it will grow to $11,000 after one year. You make $1,000.
In year 2 (and every other year), however, you make increasingly more (because you’re earning 10% on a growing balance).
At the end of 10 years, your investment will be worth $26,000 (we’re rounding to the nearest thousandth).
The Value in 20 Years
Now it’s your turn. Which price is right—i.e., what would you guess the value would be at the end of 20 years (after continuing to compound at 10% per year)?
We’re really just looking for a guess, you don’t need to calculate it—unless you really enjoy math:)
(For those who care, the formula is: 10,000 x 1.10^20, where the little carrot thing means raising 1.1 to the 20th power, i.e., for 20 years.)
The correct answer is: $67,000.
The Value in 30 Years
Let’s compound another 10 years. What would you guess the value would be at the end of 30 years?
Again, we’re just looking for a guess.
Pay attention to how the change from 20 to 30 years compares to the change from 10 to 20 years. If you read our Core Post No 2 about the importance of always putting investment questions in context—i.e., always thinking about a time frame—you’ll start to appreciate why Time is such a big deal when it comes to investing.
The correct answer is: $174,000.
The Value in 40 Years
Finally, what would you guess the value would be at the end of 40 years?
We realize that 40 years is a long time, but you will be there eventually. The biggest regret we hear from people approaching or in retirement is that no one taught them the secret of compounding when they were younger.
Even without the formula, you might have noticed that the value was more than doubling every 10 years. In fact, it was increasing by a factor of about 2.6 times the previous value.
The correct answer is: $453,000.
By the way, if we let this compound for another 10 years, the investment would be worth $1,174,000.
And, just for fun, if a parent or grandparent invested $10,000 on behalf of a newborn child and they let it compound until they retire (we’re guessing by then the retirement age might be closer to 70), this one-time investment would be worth nearly $8 million. (And, yes, we know we need to factor in inflation—which historically runs at about 3%—but we’re still talking a significant amount of money.)
And for those wanting to look beyond their own lifetime, compounding is even more powerful when it comes to establishing generational wealth.
By the way, if you were paying attention, you likely noticed that it was easy to guess the answer because the first two options didn’t make any sense if you just compared them to the previous balance.
The reason for this is that the first answer was being compounded at 3% and the second at 5%.
Scroll back up if you need to in order to appreciate how important the compounding rate is. The difference in values is staggering, especially over longer time periods.
So, why did we use 10%, 5%, and 3%?
These are roughly the long-term compounding rates for the three major asset classes: Stocks, Bonds, and Short-term Investments.
Once you grasp this, you can begin to appreciate how risky it is for long-term investors to move out of Stocks into Bonds or Short-term Investments.
This is usually done with the thought that you’re being more conservative, but that’s a misconception. The amount that you potentially sacrifice by moving out of stocks could mean the difference between achieving or not achieving your long-term investment goals.
That said, never put Stocks in your Short-term Portfolio (money you’ll use over the next 5 years).
The point of this post is only to focus your attention on how compounding works. You won’t compound at a constant rate in the real world, but we’ll get to that later.
Finally, if the notion of compounding seems a bit too much of a math thing, it might help to think of investing as your money going viral.
We’ll build on all of this in future posts.
Stuart & Sharon Crickmer