The truism "it takes money to make money" applies to many situations. Fortunately, when it comes to building a nest egg, I find that all it takes is a little money early on to potentially make a lot of money in retirement. As a financial consultant managing other consultants out in the field, I like to demonstrate this principle in a more precise—and compelling—fashion, with one simple mathematical equation that I'll share with you.
72: It's all in the math!
In my years of meeting one-on-one with TIAA participants, I've found that basic math works better than emotional discussions in motivating people to save more money. And nothing demonstrates the power of compound interest more elegantly than the numbers 7 and 2—especially to savers with plenty of time on their side. Here's how…
1) First, the rule of 72 states that an investment with an average annual return rate of 7.2% is set to double every 10 years. That's right! Double.
Here's a rule of 72 example: If 20-year-old Sarah invested $1,000 today and just left it there until she retired at age 70, she could end up with something like $32,000. A 32x increase! Based on the historical, long-term returns of US large-cap stocks, the assumption of 7.2% growth is very reasonable (of course, as always, past performance is no predictor of future returns). If Sarah waited until age 30 before investing that $1,000, she would only end up with half the amount of money ($16,000 instead of $32,000) at age 70. That's why my financial consultants strive to educate those with retirement goals (and to reform lapsed savers) as early as possible— whatever excuses are thrown our way.
2) Similarly, if you assume a 10% rate of return, you double your money every 7.2 years.
Meaning, at age 70, Sarah's balance would look more like $128,000! A 128x increase is counterintuitive to the point of being mind-boggling. But if you leave money by itself for long enough, it really can start multiplying exponentially. Historically (that is, 1928 through 2014), the annual average return rate for the S&P 500 has been 10%. If you factored in reinvested dividends over that period, the figure would be even higher. Of course, if you break down this timespan into shorter periods, there is some variation: For example, the average annualized return for the three-year period, 2013-2015, was 15.13%; other periods experienced much lower averages.
On the flip side, the rule of 72 applies to credit card debt
Just like the accelerated growth on your savings, the same thing can happen—in the opposite direction—when your debts compound. And credit card providers usually charge interest rates higher than 10%, meaning those institutions are making money off of you at a faster rate. But for the sake of this argument, let's suppose Sarah's more feckless twin sister, Julie, owes $1,000 and the rate is 10%. If she avoided repayments for 7.2 years, she would double her debt! Of course, few are so irresponsible as to throw seven yearsʼ worth of credit card statements, unopened, into the trash. I use this extreme example to better show how compounding can work against you; the sooner you pay off your debt, the lower the total cost to you. Just as I like to inspire savers with the rule of 72, I find it handy to discourage would-be borrowers as well. The $1,000 shopping spree (at a borrowing rate of 10 to 18%) is costing a lot more than the original $1,000 price tag. Remember that the next time a "must-buy" designer bargain has you reaching for your plastic! Understanding the rule of 72 (really a math equation) can help you quickly understand both the potential benefit of saving early—and the cost of buying on credit. Whether you are still quite early or well into your career, there may be no better time than the present to invest in your retirement.