Compound interest may be the most powerful personal finance related topic out there. By combining time and money, a little bit today can be worth a whole lot more tomorrow. Most of us have heard about compound interest, but for me, when I sit down and run through the numbers, the power of compound interest blows my mind. In this post we are going to look at a few examples that stress the importance of starting early, even really early. For example, what if these compound interest examples were taken to the extreme and we started investing for retirement at birth? Let’s take a look.
Compound Interest Examples from Bill, Susan, and Chris
Before we get into the power of investing as a baby, let’s look at a few more realistic compound interest examples. The three individuals below are all in different stages of life.
- Susan is a college professor who invests $5,000 per year in a stock-heavy retirement account for 10 years total between the ages of 25 and 35. In total, she invests $50,000 during this period. After age 35, Susan decides to begin investing in other assets and does not put any additional money into her retirement account.
- Bill is a dietician who also invests $5,000 per year in an account similar to Susan’s, but does so over a 30 year time period. Unlike Susan, Bill got a late start to investing and didn’t begin until age 35. He invested $150,000 total until the age of 65-years-old.
- Chris is a lab technician who gets the best of both worlds by investing his $5,000 over the full 40 year period, beginning at age 25 and stopping at 65. In total, Chris invests $200,000.
Who do you think will end up with the most money? It’s pretty obvious that Chris will considering that he has the best of both worlds. But what about Susan and Bill?
Chart assumes 7% growth rate. Souce: business insider via jpmorgan.com
The main takeaway from the chart is Susan ($602,070) ends up with more money than Bill ($540,741) even though she only invests for a period of 10 years while he invests for 30 years. They invest the same amount of money annually yet the difference is Susan starts investing at the age of 25 (and then stops after 10 years) and Bill starts at the age of 35 and invests until retirement. So, Susan’s 10 years of investing beats Bill’s 30 years since she started at 25 and Bill started at 35.
This is an oversimplified example. In a real life situation, investments would likely change from year-to-year, hopefully increasing over time. The interest rate of 7% would fluctuate annually, especially with a portfolio heavily invested in stocks. However, the point here is to observe the power of compound interest over time.
Think about that for a minute. This really is a huge difference. Bill has to invest for TWENTY more years than Susan with his late start, and he will still end up with less money at retirement.
What if You Started Investing as a Baby?
I have seen dozens of compound interest examples similar to the one associated with the above graph. However, I’ve seen very few that recommend starting to save for retirement even earlier. After additional research, the Google machine returned a few articles focused on starting investing as a baby, though similar content is rare.
Therefore, let’s add someone else into the mix along with Susan, Bill, and Chris. Let’s say Johnny was born in the year 2018.
When Johnny was born, someone in his family made ONE $5,000 lump sum payment into a retirement account. For consistency, assume a growth rate of 7% and a retirement age of 65.
By making ONE payment of $5,000 when Johnny is just a tiny baby, he would have nearly $500,000 at the age of 65. Little Johnny’s money would be worth a multiple of 100 times just by placing it in an account and letting it sit there making an annual return of 7 percent.
To reiterate, Bill would have to make 30 payments of $5,000 starting at age 35 to have roughly the same amount as baby Johnny’s ONE payment.
I get it that this example doesn’t factor in inflation. For example, the purchasing power of $5,000 in the year 1982 (35 years earlier) would have been $1,946. With that being said, this still demonstrates the amazing power of compound interest. Even an investment of $1,946 would be worth nearly $200,000 at the age of 65.
More Thoughts on These Compound Interest Examples
Why isn’t compound interest discussed more broadly? Especially investing even before entering the workforce. Well, I’m not sure but I can speculate.
- Babies don’t read Business Insider articles (or personal finance articles in general). Therefore, the audience for personal finance articles is usually adults anywhere from recent college graduates to retirees.
- It’s weird to think about your newborn baby getting to retirement age. It just is.
- Similarly, 65 years is a really long time away and most parents only have financial responsibility for their children through college.
- Most parents won’t live to see their children turn 65. Nobody wants to think about that.
To summarize, if you have a few thousand dollars laying around and a child on the way consider throwing that money into a brokerage account and let it grow until your little bundle of joy reaches retirement age. I know that most people don’t have that kind of money available, but that really wasn’t the point of this blog post.
The purpose was to show a few compound interest examples and how important it is to start investing in retirement early, whether that is at age 1 or age 25. If a person takes only one thing away from the personal finance world, it should be an understanding of compound interest. It is so powerful!