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I VIVIDLY REMEMBER my father explaining how small sums of money could grow exponentially. Using the example of a penny that doubled every day for a month, he showed how it could grow to more than $10 million. Indeed, as Albert Einstein didn’t say, “The most powerful force in the universe is compound interest.”
Many authors tout the benefits of saving beginning at a young age. Radio personality Dave Ramsey and his daughter Rachel Cruze, for example, compare two individuals. One starts saving early and puts aside a modest sum annually for eight years, and then stops. The other begins eight years after the first, investing the same modest amount for 35 additional years. The first person comes out ahead.
Admittedly, their eye-popping conclusion depends on an absurdly high 12% constant rate of return. No investment can guarantee double-digit growth rates year after year. Certificates of deposit and some bonds might offer consistent returns, but rates tend to be relatively low. The stock market can deliver much higher returns, but not with any predictability.
That brings me to our twins. They graduated from college in 2016. I figured this was a good time to take advantage of their youth and start them on the path to wealth. I talked to them about compounding, and how powerful it can be when combined with early and consistent savings.
The idea was to have them amass a relatively small amount in tax-deferred accounts prior to age 30. As I explained it, they could “go big early” and then ease up on the gas. This wasn’t a free pass to skip investing once they reached their initial goal. Rather, the idea was to set aside a basic sum to fund their life many decades later. They liked the concept.
Together, we set a goal of saving $3,750 a year in an IRA. As an incentive, my wife and I promised to contribute half that amount, meaning they’d need to save roughly $150 a month to reach the annual goal. If all went according to plan, they would have socked away $30,000 by the time they turned age 30 seven years later.
They’d then leave those savings to grow for 35 additional years. Two rules were implicit: The amount set aside was untouchable and dividends must be reinvested.
To get an idea of the power of compounded savings, I had them plug numbers into an S&P 500 return calculator, looking at some random 35-year periods. They were astonished at the final numbers.
For instance, the 35-year period ended March 2024 had an annualized total return of 10.19%, similar to the S&P 500’s average annual 10.26% return since the index’s 1957 inception. A $30,000 initial investment would have grown to a final portfolio value of $900,000. This figure isn’t adjusted for inflation, and it includes reinvested dividends.
I then discussed the income this portfolio might generate for their 65-year-old selves, assuming a 4% withdrawal rate. They’d have some $36,000 a year to begin retirement—not all that high, but certainly nothing to sneeze at. The amount represented $6,000 more per year than the entire initial investment.
A lightbulb went off in their heads. What if they continued to save after the initial seven-year saving period? A mere $200 per month, or $2,400 per year, through the 35 years to age 65 would goose results to over $1.54 million, giving them an initial retirement income of just north of $61,600 per year. What if they invested $500 a month? That would become more than $2.5 million dollars, providing over $100,000 per year.
Before they got too excited, I noted that projected outcomes weren’t guaranteed. Looking at all 35-year stretches, the S&P 500 has produced an average annual return of 6.6% after inflation. Still, there were no 35-year periods when the S&P 500 lost money.
The twins agreed to try the concept. We sat down together each year to make their contributions and to discuss the investment plan. Initially, they invested in SPDR S&P 500 ETF Trust (symbol: SPY).
This past March, they turned 30 years old. During the initial time, their accounts benefited from a strong annualized return of more than 13%. The positive early growth solidified their decision to stick with the plan.
There were tweaks along the way. For example, my daughter started medical school and had no income to contribute in two of the first four years. She made additional contributions when she began her residency. The twins decided to slightly broaden their portfolios by purchasing Vanguard Total Stock Market ETF (VTI) and Invesco’s technology-heavy Nasdaq-100 ETF (QQQ). They switched to Roth IRAs to take advantage of their lower income tax brackets. Recently, they’ve started saving the maximum allowable IRA contribution.
As Einstein also didn’t say, “Compound interest is the eighth wonder of the world. He who understands it, earns it.” The combination of starting early, saving regularly and compounding is indeed remarkably powerful—and you don’t have to be a genius to benefit.
Jeffrey K. Actor, PhD, was a professor at a major medical school in Houston for more than 25 years, serving as an academic researcher with interests in how immune responses function to fight pathogenic diseases. Jeff’s retirement goals are to write short science fiction stories, volunteer in the community and spend time in his garden. Check out his earlier articles.
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I applaud your planning and good intentions.
But it needs to be said – the ‘power of compounding’ only works if the market is yielding positive returns after inflation and investment costs. There’s no reason to believe this will continue. “past performance is no guarantee of future results”, as every mutual fund will tell you. So I rather disbelieve in the power of compounding, which only works in an abstract mathematical sense, or as long as number go up.
My experience with saving lots before the age of 30:
the S. African stock market had negative return over fifteen years, while inflation ran in double digits and the currency devalued. This utterly wiped out ten years of retirement savings. I should have bought a sports car instead. With reasonable maintenance it would still have been worth a couple of thousand, and I’d have had all the fun of driving it.
The power of compounding works in reverse too, when the markets are going down. The concept which is mathematically sound, unfortunately breaks down on the assumptions that are required – low inflation, steadily increasing market indexes, skillful stock picking/mutual fund picking. These may not happen..
But, it’s the only game in town, and we have to play it, with our hearts in our mouths for decades on end..
Here is another idea to convince others.
Compare:
25-year person saves $1000 monthly for 10 years and stops.
35-year person saves $1000 monthly for 30 years.
10 vs 30 years assuming the same rate of return.
Who would have more money at age 65? the 25-year