What would you do if you found yourself in the following position?
You win the lottery, and they give you the ability to take your winnings in one of two ways. One, you can receive $1 million today. Or two, you can collect one penny today and then each day for the next 30 days the amount doubles.
Which option would you choose?
The lump sum $1 million certainly seems appealing. After you double the penny 30 times, however, you end up with over $10.7 million dollars. Under most circumstances you would be crazy to choose the $1 million.
More than likely you have heard some version of that proposition, so the correct answer may not come as a surprise. In general, though, we humans are surprisingly bad at appreciating compounding. That’s the technical name for what happened with the penny doubling every day. It compounded over 30 days.
The penny example is extreme. You would be hard-pressed to find an investment that generates those types of returns. But with a long enough runway, even much smaller returns can produce tremendous results.
The key is time. The earlier you start investing the more times your money can compound.
With compounding, you earn interest on the principal amount, plus an additional amount on money that was previously earned as interest. This cycle of earning interest on interest is the magic behind compounding.
To give you a more realistic example of what the power of time and compounding can do for you, let’s look at Bob and Tom.
Bob started saving as soon as he started his career. For 10 years, from age 25 to 35, he stashed away $5,000 a year. At 35, with several young kids and the purchase of a new home, he stopped saving for retirement. Unfortunately, he never returned to saving for retirement from that point on.
Tom was the opposite. He decided to live it up in his younger years and did not begin saving until age 35. Tom, however, stuck with it once he started. He saved $5,000 each and every year from age 35 to 65, a 30-year timeframe.
Bob saved a total of $50,000. Tom, who started saving later, saved $150,000. Each earned an 8% annual return, and neither one took any money out of their accounts.
So how did they fare?
At age 65, Bob’s account was worth nearly $760,000. As for Tom? His portfolio amounted to $590,000. Tom ended with $170,000 less but saved three times more. How is that possible?
The answer is time. Bob started saving 10 years earlier. He used time to his advantage.
The problem for most young people is that they are juggling debt – vehicle, education, or credit cards – saving for a house, and trying to enjoy life while they are still young. For many, this pushes back saving for retirement until a later date.
But the key is to start today. Even if it is just a small amount. With enough time and a decent return, those small sums will mushroom into more than you can imagine.
I can’t end this article without mentioning one other anecdote on the mind-boggling power of compounding. Unlike the doubling-penny example, I bet many of you have never heard this one.
Pretend you have a piece of very thin paper – think of the material a Bible page is printed on. The paper is the size of a full-spread newspaper. Now, let’s say you fold the paper in half 45 times. How tall would that folded paper be after the 45th bend? Any idea?
Answer: It would reach to the moon.
Think about that. That’s the same power you harness when you invest prudently and let time work for you.