As a personal finance blogger, you’d think I’d have a pretty good understanding of compound interest by now.
I thought I did, right until I ran a little experiment that shocked me to my core, and nearly two weeks later, still has my head spinning.
The experiment
It’s funny. As an obsessed money geek, I’ve probably ran through my financial scenario a thousand times.
At a moment’s notice, I can whip out a financial calculator and start measuring what sort of impact minor investment changes will have on my early retirement in a decade.
But even though I’ve played through those scenarios so many times in my brain, last week, I realized something kind of amusing:
In all those thousands of calculations, I don’t think I’ve ever assumed I’d retire at age 59.5. (The government’s “normal” retirement age, as outlined in your 401k’s minimum withdrawal date)
So, what if I didn’t retire until age 60?
For fun, I made one tiny adjustment to my usual calculations. Instead of making the time frame 10 years, I made it 32.
The result?
Say what??
Yea, I need to repeat that to myself to let it sink in…
The $230,000 I’ve already saved in my 20s is enough to all but ensure I’ll become a multi-millionaire by 60, even if I never save another penny in my entire life.
To clarify, that potentially $2 million portfolio is not:
- What would happen if I kept working and saving like a maniac on a mission.
- The result of some brilliant, market beating investment performance.
- Completely devalued because of inflation.
Instead:
- That’s $1.5 to $2 million adjusted for inflation.
- The $500,000 range is simply the difference between a 6% and 7% return, which is right in line or even a little conservative compared to historical stock market averages.
- And craziest of all, our scenario assumes I never save or earn another cent. It literally assumes I’ll live paycheck to paycheck for the next few decades, never saving a dime, and then just letting my current portfolio carry me to the finish line.
A FINISH LINE WITH $2 MILLION AT THE END.
So, is saving money worth it?
Uh, ya it is!
The only “sacrifice” I made to build that $230,000 was avoiding debt, passing on a few cars and electronics, and saying no to a mansion. In fact, I’d say it just might be the easiest $2 million I’ve ever made.
How can anyone set themselves up to be a multi-millionaire?
What did I do to put myself in this spot? Sorry to be anticlimactic, but all I did was:
- start early
- invest in index funds (aka the most boring and simple investment ever)
- let compound interest run its magic.
Sure, I still plan on retiring early, which most likely means withdrawing that nest egg before it gets a chance to reach millions. But wow… does it feel good knowing that by all mainstream standards, I’ve already made it.
Most people won’t take the simple steps
Sometimes I find myself a little jealous of the carefree mentality most people take towards their money.
I do wonder what it’d be like to be able to walk into a car dealership and plop down an entire year’s salary on a hunk of metal without flinching. Maybe that’d be fun, to spend like you have no future?
But of course, we know where that ends. It leads to a temporary satisfaction, then a lifetime of money struggles.
Most people never dig themselves out of this rut. Even more common, they never see the need to, since everyone else is stumbling through life, making the same money mistakes right along with them.
It’s amazing to me how these “normal” decisions can add up to a lifetime of stress. 98.5% of people will never reach a million-dollar net worth, and yet, the solution to get there is staring them right in the face, every day.
We’re all given two choices:
- You can live beyond your means today, which ensures you struggle forever.
- You can live a little below your means for a few years, and before you know it, you’ll be as surprised as I am to find out you’re set for life.
Take Advantage of Compound Interest To Lock Up Your Millionaire Status
If you’re reading these words, don’t underestimate the incredible opportunity you have today.
Even as much as the topic is brought up, we humans struggle conceptualizing the power of compound interest. It’s nothing to be ashamed of, our brains just aren’t hard-wired to intuitively grasp such a wild mathematical concept.
Compound interest is hazy. It’s confusing. It’s really freakin’ hard to imagine small percentage multiplied for years and years on end.
Michael Batnick once explained it. If I ask you to calculate 8+8+8+8+8+8+8+8+8 in your head, you can do it in a few seconds (it’s 72). If I ask you to calculate 8x8x8x8x8x8x8x8x8, your head will explode (it’s 134,217,728). –Morgan Housel
(Yes, that’s a quote of a quote.)
Our experiment shows that compound interest is probably way more powerful than you or I imagine. Obviously, it caught me by surprise.
Don’t let it catch you by surprise. Start taking action today.
With just a few years of responsibility early, you can set yourself up for millions of dollars later.
Anyone want to join me in the slow, steady, and shockingly easy race to becoming a multi-millionaire?
So true! It really is hard to wrap your head around it, but the numbers don’t lie. This is a must read for anyone just starting their careers (or even earlier)
Thanks Young FIRE Knight!
I really like the concept. I have been thinking to myself. if you save to live later, and something happens to you, God forbids, you will not enjoy your accomplishments.
You don’t know what tomorrow holds, should we put all our hope in the compound interest?
let me know what you think
Oh, Arthur, you philosopher, you!
Money wizard,
Great post as always! One quick question: you said this calculation is inflation adjusted, but the calculator screenshot seems to suggest otherwise. To my understanding, the historical return of 6-7% should be adjusted down by 2% expected inflation to 4-5% (hence the 4% rule). Am I missing something here?
The 6-7% assumption is already adjusted for inflation. The stock market’s long term, non-inflation adjusted return is actually around 10-11%. Play around with this cool calculator for more info:
https://dqydj.com/sp-500-return-calculator/
Ah I see, I didn’t realize you were using total returns. That was the main thing that tripped me up, since most long term projections I see in both blog universe and in-industry show 7-8% as long term nominal projected (price) return.
While 10-11% is certainly one projection for the long-term total S&P return, I wouldn’t call it the most conservative one (but I hope you are right!). One is the calculator link you attached (very handy tool btw, I’ll be saving that one) is that the majority American market history saw much higher dividends compared to today’s market (aka the railroad/industrial revolution days) – see link. All that compounding produces a figure that feels a bit boated.
Great content as always! Sorry to be detail obsessive, but at least you know I’m following the journey closely!
http://www.multpl.com/s-p-500-dividend-yield/
Compound interest is extremely powerful, but the trick is getting it for a full 32 years.
I wrote a post about all the forms of compound interested on my blog, but really it comes down to two things — continuously saving and reinvesting the money you earn AND continuously reinvesting the money your investments earn.
That last one is much harder to do because the money is out of your hands.
Feel free to link that post here in the comments. Would love to read it!
I love these calculators and running this different “scenarios” all the time! Great share.
For me, once you see these numbers you start to feel safe and think, what’s next? Can I ask the community the same question?
What are some other sources of income to focus on today/near future to get close to Financial Independence?
–Real Estate
–Blogs
–Continue high savings rate and investments in Index Funds
–Anything else that can help speed up the process?
Patience is key and I love this convo’s, just curious any additional avenues to speed up the FI process + add to the cash pile 🙂
I’ve got a follow up post coming, which will look into my different early retirement options now that the big portion is saved for. Stay tuned!
I like to think of my real retirement funds and retire early funds as separate. If you can get 100-200k in your 20’s, you are right, your done with real retirement funds! That’s a line item expense that you don’t have to worry about anymore. Then you can start funding your life transition plan! Congrats of fully funding that big (and often stressful) expense!
Would like to hear a little more about this….so, at $100k in your 20’s, you are saying retirement nest egg saving is done, and one should be saving for early retirement in separate vehicles?
you gotta have things that are already taxed to retire early and balance those with 401k/ira just to be able to access those dollars in early retirement. roth ira would come first for after tax funds for the tax free w/d later in life and after tax brokerage or real estate or something else to fund your life until 59.5. you would also want a pile of safety cash if you’re going to peace out fairly young. it’s not as simple as jack it all into a 401. i hope this helps and feel free to verify what i’ve said here.
Another great post Money Wizard! As a 23-year old taking his first steps into investing I’ve learned quite a lot from your posts! Thanks to your tips I’ll hopefully pass €100k net value this month 🙂
I do have 1 question: when you state the $1.5-2 million number you say it’s “adjusted for inflation”? But in the figure showing the precise details you do not adjust for inflation? If we take a yearly 2% inflation rate into account, in 32 years life will have become around 1.88 times more expensive. Thus, by dividing the $2 million by 1.88 we are left with a purchasing power of roughly $1.06 million. Which shows a considerable difference with the $2 million you stated. Or am I seeing this wrong?
Regards from Belgium!
Awesome to hear Dieter! Congrats on your progress!
See my earlier comment for the answer to the inflation question. Long term, the non-inflation adjust market return is over 10%. The 7% figure you hear quoted so often already subtracts the 2-3% of typical inflation.
Hi Guys,
Few questions. Guess,I have been a money miser and saved around money. A few questions are:
1. Do you include the value of the house in the estimate of net worth? Or is the target to have shares of a certain value as well as a house before retirement?
2. If most of savings is in the house we live in, does it create any problem for retiring early. I.E. a share capital of say $150,000 and houses of $800,000?
3. Given the cost of selling houses, how can we change the savings from house to share capital?
Any thoughts,
thanks in advance,
Rav
Great post. I actually use a compound interest calculator as well and saw that if I did not invest another dime, adjusting for inflation I could have around $1.1-1.4M. All that being frugal in my teens and 20’s has paid off. I recently did a post on my blog where posted a snapshot of the last car payment I made ever in 2009! Without that monkey on my back I have been able to do so much more. I advocate for less car, more saving. Better to be investment rich, than car or house poor. I say pay off all debt and then invest a high 25-50% of your income. That is how I built a six-figure retirement in the span of 6 years.
Thanks,
Miriam
Love it! Congrats, Miriam.
Great post.
I had this epiphany a few months ago as well. At 27 I’m done saving for traditional retirement age. time to buy a boat! or i could pass on the boat and retire 2 decades early
Congrats Dan! Awesome feeling, isn’t it?
I’d probably shoot for a few decades of freedom rather than a boat too 😉
Great feeling, the alternative to the boat is that become a lifty or ski patrol and spend every penny but still get a cushy retirement. That seems better than a boat too. But ill probably just keep working.
Rent the boat and retire in one decade, 9 years, and 11 months:)
Compound interest in magical BUT keep saving! That $2 million will be worth much less in tomorrow’s dolllars than today’s. I believe inflation will soon be rearing it’s ugly head and it will be felt by all households.
Your assumptions are good ones, the fact that if you don’t contribute a single penny beyond your current savings, earning 7%.
Play around with other assumptions, like maintaining your current savings rate and compound/amortize that amount. Also start making new assumptions with a 4% inflation rate. This will spark a new interest in increasing your current savings rate!
If future returns are anything like historical, that $2 million is likely to actually be $4+. See my earlier comments talking about return rates.
That said, past performance certainly isn’t a guarantee for future returns, which is a great reason to play around with the assumptions like you’re saying. Thanks!
I have a question that is more specific to the calculator, I took the periodic deposit/annuity payment per period (PMT) to be the yearly contribution you make – say $24000 if you max out an IRA and 401k in 2018. Selecting PMT at the beginning or end of the compounding period creates quite a difference, which makes sense, but I’m making monthly contributions so it isn’t really a lump deposit at the end or beginning of the year. Is the calculator accurate for monthly contributions? Am I thinking about this the right way? The end of period could be a good conservative number, but I’d like to calculate based on monthly increases to get a more accurate number.
You are correct. You could adjust for monthly contributions by multiplying the number of years x 12, dividing the annual payment by 12, and dividing the interest rate by 12. Happy calculating!
I really appreciate reading your story, though I’ve found Personal Capital’s tool to be a great way to understand the power of compound interest against my own retirement plan.
Like you, I remember being surprised a while back when I realized that even if I stopped saving today that I’ll still easily get to inflation-adjusted millionaire status well before the traditional retirement window hits. It was, and is, a comforting assurance to know that even if I lose my job or some other financial woe hits that we’ll still be comfortable in retirement. I don’t expect we’ll need to play that particular card (who does though, really??!!) but even with our house paid off and no debt, our plan is to pay market rate, out of pocket, for much our kids’ college expenses so that they can start life without the burden of ruinously-high student loans. I suppose we could be saving toward college, but in our case it’s just made sense to get our house paid off and funnel money in to our long-term savings (though we do have an emergency fund for, well, emergencies…)
I sleep much better at night knowing that even if we have to tap the brakes at some point on retirement savings to get through about a decade of college bills, that we’ll still be able to afford the retirement we’re counting on.
Awesome to hear Ken, thanks for sharing!
Interesting idea, it sounds we should include this as an early milestone in the list of goals to achieve financial security 🙂
Maybe so! Definitely a neat milestone – probably the coolest one I’ve crossed yet.
… calculate desired income … say $80,000
… calculate 3% inflation for 32 years
… desired income in 2050 dollars then is $206,000
… 25 x $206,000 is 5 million plus etc etc
… you will need 5 mill… ?
That’s why we adjust the rate of return from the historical 10-11% rate to 6-7%. The 3-4% difference represents the effect of inflation. In other words, the $1.5-2 million is already adjusted for inflation and would provide the same amount of income as $1.5-2 million today.
In other words I’d most likely be looking at $4.9 million in my portfolio at age 60, since that’s the value you get when you run the numbers without subtracting inflation (aka using a 10% rate of return).
Cool!
Yeah, maths is cool. I sometimes wish I got my act together in my twenties instead of my thirties as compounding would make it much easier! But always better today than tomorrow, and I love watching my investments grow. I’m looking forward to the day they earn more than me, but not sure I’ll make it there as I’ll FIRE by then!
I wish I had someone telling me this stuff when I was in my 20’s. My parents didn’t, my school didn’t. My workplace didn’t. Unfortunately it isn’t common knowledge, yet it is so unbelievably important. I found out this stuff fin my 30’s which is better than later, but I have still missed out on valuable years. I will be passing on this information to my young daughter. It is such a common regret of the elderly – not starting saving earlier.
So true Nick, and a huge mission for this site. Thanks for sharing.
Interesting and comforting thing to find out Mr. Wizard. Congratulations on your succes and nice blog you have here. I’ll be following you along!
I wish I had the financial knowledge that is now so easily available because of the internet back when I was younger. Time is the key and as a physician I had several things going against me (just delayed start from training put me behind the 8 ball). But I wholeheartedly agree that compound interest is one of the easiest paths to wealth (Einstein called it the 8th wonder of the world).
Compound interest is very real. My actual numbers: 1994 my net worth was -$2K (graduated college). 2007 I reached my first net worth $1M; 2013 $2M; 2016 $3M; 2018 $4M. If you look at these time frames they nearly halve each time to reach next million: 13 years, 6 years, 3 years, 2 years. I becomes a snowball. My saying is “Note everyone can be a millionaire but anyone can be a millionaire”. I am proof.
Many variables. If your $230k becomes $1.5 million but a loaf of bread is $12.50, you might have a problem.
Sequence of returns is your biggest risk. If you stay stock heavy and have a 50% decline in “the wrong year”, you might never get close to your $1.5 million over the next 5-10 years.
Compounding only works as expected if you get a steady/certain/guaranteed 5/6/7%. You don’t with stocks or bonds. CDs will give you a fixed return, but not enough to power you to $1.5 million.
Best is to keep saving and have the “right” mix of stocks/bonds/cash that matches your need/desire to take risk.
Inflation is already accounted for in our example. By subtracting out 3% of returns per year, our $1.5 to $2 million should buy exactly as much as $1.5 to $2 million today.
Sequence of return risk is very real, but the 7% expected return you hear quoted is the market’s geometric return, not the average. In other words, it’s already considered the effect of unsteady returns. So, at least historically, our 6-7% assumption isn’t perfect, but it should be reasonable. Here’s a fun calculator.
An interesting way of looking at things since I have similar amount saved and I am about the same age. I’m not totally sure that I want to totally stop working while I’m healthy and youngish but maybe I should consider cutting it way back in the next few decades and donating more of my time and money to good causes.
Thanks for the great post! What do you use for your index funds? I have been thinking about leaving my financial adviser (and those fees!) and going it alone with Vanguard or Betterment.
I <3 Vanguard.
https://mymoneywizard.com/5-reasons-vanguard-funds-best/
https://mymoneywizard.com/ultimate-index-fund-showdown-vanguard-vs-betterment/
Really good stuff and congrats on the savings you’ve accomplished in your 20’s!! I am late to the game but happy to be here. There are a lot of factors which will allow me to hit FI before normal retirement age, but ultimately it comes down to a high savings rate.
Happy to see you around!
And I agree. It’s all about the saving’s rate.
Got a question here. How does compound interest work in index fund (vanguard)? From my understanding, the return in index fund are based on price volatility (how much the price changes)
Yes, at the most fundamental level, the index fund’s price grows in response to the underlying earnings of the companies within that index fund.
Thanks for the reply. I think my question is a little confuse here. What i meant was, does compound interest apply on investing in index fund? How do we earn compound interest in index fund?
Seems like we are pretty close in age, you’re where I plan to be financially be 30 if everything keeps up. Hoping I can hit that FIRE date in a similar number of years. Best of luck, Wizard
Great Article, new to your posts. Looking great man!
I had the same realization about 3 months ago… I’m 38 with over 1M, although my expenditures are a bit higher ($93k annual expenses) and I have a 52% savings rate.
I’m looking to retire at 50, with a 3.25% withdrawal. If you haven’t already, I’d look at the “safe withdrawal rate series” over at earlyretirementnow.com… I had always questioned the 4% rate, and I think this dude does a really great job with analysis.
Anyway, keep on keeping on man. Good luck to you.