When I first stepped into the working world, I had encountered billboards and advertisements emblazoned with slogans sounding like the blog post title and showing a picture of a man/woman in a graduation gown and/or a young-looking office executive. Back then, being young (and foolhardy), retirement was the last thing on my mind. Come on, there is still at least another 30-plus years to go for me before reaching that stage, and I will think about it “when the time comes”.
Yes, that “time” came just about seven to eight years ago for me, at where I was nearing the halfway point of my working life. Suddenly, that slogan made some sense. The very essence of those messages was hiding in plain sight all along, and it took me that long to realise it. That essence is the power of compounding.
Power Of Compounding
Most of us had learnt the formula of compounding during our math lessons, which is:
Final Amount = Principal x (1 + Interest Rate) ^ Number of years
(Assuming annual compound)
In school, this formula was used typically for calculating bank interest or final bank deposit amount after a certain number of years, but it works well in knowing how much one is getting after a certain period with a definitive rate of return. Hence, the formula can be modified to:
Final Amount = Principal x (1 + Return Rate) ^ Number of years
The ^ sign is the “power of”, which itself is a very powerful (pun intended) arithmetic function. Adding one to the “power of” would bring a huge jump in the overall result, as shown:
22 = 4, 23 = 8, 24 = 16…
Naturally, if the number of years is larger, the final amount would be larger, too. Coupled with pictures of young people in the mentioned billboards and advertisements, it all made sense now: when one is young, the number of years to retirement is a lot, and factoring in compounding, you are likely to end up with a larger final amount than those who started off much later.
A Race Between Two Individuals
Taking the concept of compounding up a notch, let us have two individuals who are of the same age, X and Y, and a financial product P that generates 5% returns a year. X started investing in P when he was 21 with an initial amount of $10,000 and contributed $5,000 per year for the next 10 years. Y started investing at age 40 with the same initial amount of $10,000 and contributed $5,000 per year for the next 20 years. By age 60, X ended up with $338,852 while Y finished with $200,129, despite the latter contributing more than the former1. The result showed that compounding works best with a longer time horizon, which works well for X, so it pays off when one invests at a younger age.
Clearly for my case, I am Y in the story above. But fret not, for I am giving you this advice:
The best time to plan for retirement was 20 years ago. The second-best time is now.
Go for it.
1 – The Bedokian Portfolio (2nd Edition), p68-70