Key Take-Aways
- For many, the formula for wealth is a linear function of income minus expenses
- The path to building long-term sustainable wealth requires a break from the linear function tied to individuals efforts and investing provides the simplest way to decouple your wealth from your effort
- Investing protects wealth against inflation and helps grow wealth at an exponential rate
- Investing in productive assets like stocks and real estate allow individuals to benefit from the power of compound interest and build their wealth in a non-linear fashion
- Platforms such as M1 Finance and Fundrise enable individuals to easily get started investing in stocks and real estate
Why is investing important? If you are here, you are probably interested in increasing your overall financial well-being—maybe that means building a small safety net, saving for retirement, or aiming for FIRE. Now the biggest factor to your financial well-being is undoubtedly your savings rate, however, it is what you do with your savings that will either help or hinder you on your path to financial freedom. Whatever your goal, investing is a key piece of that puzzle. Investing not only protects your hard-earned money from the negative impacts of inflation but also provides a platform to leverage your efforts and grow your wealth independent of your effort. For the average person, their wealth is determined by a simple formula:
Wealth = (hours worked x hourly salary)-expenses
With the above formula, an individual’s wealth is limited as the only way to build wealth is to work more hours or spend less. Both of these factors are important, but investing introduces a new variable that helps you break free of the above formula’s limitations by having your money work for you. For this reason, investing is a key tool to help build wealth over time.
What Is Investing?
Investing comes in many forms, and it can be as simple or as complicated as one likes, however, investing is simply the intentional act of setting aside money today and using that money to purchase productive assets, to obtain future positive returns. The assets can range from anything such as stocks and bonds to real estate and cryptocurrencies. With the rise of firms like M1 Finance it is now easier than ever for individuals to build a diversified portfolio of stocks and bonds using low-cost ETFs such as VTI and BND to build a robust portfolio. For folks wanting to invest in real estate without the hassle of direct ownership, firms like Fundrise allow individuals to build a hands-off diversified portfolio of real estate holdings.
The Power Of Compounding
The true power of long-term investing comes from the power of compounding returns to create exponential growth. Compounding is a powerful force and can help or hurt your financial well-being. Within investing, compounding refers to an asset’s ability to generate earnings and then have those earnings generate additional earnings. As an example, if you have $100 invested for 1-year with a 10% return, after one year you will have $110—making a gain of $10. If that is then invested for an additional year at 10%, you will have $121, after a gain of $11. In year 1, you made interest on the $100 you put in, but in year 2 you earned money on your initial $100, and the $10 earnings from year one—in year two, your money is making money.
Now, focusing on U.S. stocks, as measured by the S&P 500, from 1926 to 2021, investors enjoyed annualized returns of roughly 10.5% before inflation and around 7.5% after inflation. Focusing on compounding again, those inflation-adjusted returns compounded would grow an initial investment of $1,000 in 1926 to $963,394 by the end of 2021—assuming you did absolutely nothing but reinvest dividends received. Granted few have the investment timeframe of 95 years, but this helps illustrate the power of long-term investing and the benefits of compounding.
This same principle works in real estate, bonds, and other assets. Alternatively, compounding can also work against you as seen all too often with high-interest credit-card debt. The same power of compounding can work to quickly grow a small credit debt into a large one, which is why it is so important to ensure you always pay off your credit cards as soon as possible.
The Rule Of 72
When discussing the power of compounding, the rule of 72 often appears. The rule of 72 provides a simple way to calculate the doubling period of an investment given a rate of return. For example, assuming an investment grows at 10% a year, we can estimate the doubling time using the rule of 72 by taking 72 and dividing it by 10, our assumed rate of return. According to the rule of 72, our investment would double every 7.2 years. Though not exact, the rule of 72 provides us with a quick way to compare the doubling time of different investments.
Time In The Market
With a firm understanding of the concept of compounding as well as the rule of 72, we can now turn to a practical example that takes advantage of what was just learned by comparing two investors who both experience the same annual rate of return of 9%, the only difference is one starts earlier than the other. Note you can replicate these results using the free awesome tool shared by the SEC found here, you can also play with the numbers to model something that better aligns with your personal situation.
Early Earl
Earl starts investing at 20 years old with an initial investment of $1,000 and then contributes $250 every month. Earl reinvests all dividends, and never withdrawals the funds until the age of 60. After 40-years of consistent investing, Earl’s portfolio grew to a total of $1,045,057. Throughout 40-years, Earl contributed just $121,000, the remaining $920,000 came from the power of compounding returns over 40-years.
Late Larry
Larry starts investing at 30 years old with an initial investment of $10,000 and then contributes $500 every month. Larry also reinvests all dividends received, and never withdraws the funds until the age of 60. After 30-years of investing, Larry’s portfolio stands at $950,522, and in total Larry contributed $191,000. Larry’s total dollar return was $759,500.
So What Happened?
Comparing Earl and Larry shows the power of starting your investment journey early. Even though Earl started with just $1,000 compared to Larry’s $10,000 and although Earl only invested $250 a month versus Larry’s $500, Earl’s final nest egg was greater than Larry’s. How’s that possible? Despite Larry’s advantage of starting with a larger pot of money and larger monthly contribution, Earl was still able to finish with a larger nest egg by harnessing the power of time and compounding. According to the rule of 72, at a 9% rate of return, the doubling period is roughly 8-years, which means the extra 10-years in the market allowed Earl’s investment to enjoy an extra doubling cycle compared to Larry’s investments.
Lastly, though Larry started late, his results showcase the power of starting. Yes, Larry ended up with less and had to play catch up by starting with $10,000 and investing $500 a month, but his results are still significantly better than someone who doesn’t invest. There is a saying, “The best time to plant a tree was 20 years ago. The second best time is now.” and the same is true for investing.
Conclusion
For many, wealth is determined strictly by the number of hours worked and the hourly wages. As a result of this, the only way to increase wealth is to either increase hours worked, increase hourly wages or both. This formula is undoubtedly foundational, however, it alone will not get you to a position of financial stability, as that requires decoupling your wealth from your efforts, and investing offers the simplest way to leverage your previous efforts to help your future self. Investing in productive assets like stocks, bonds, and real estate helps your money fight off inflation, while also allowing your money to grow independent of your efforts. Getting started on your investment journey earlier is always better as we saw when comparing the results of Larry and Earl, as more time invested allows you to harness the power of compounding returns over time. However, we also saw that even if you start late, you can still produce impressive results if you are willing to take the steps necessary. Apps like M1 Finance and Fundrise, enable you to easily invest with as much or as little money as you want. Read How to Start Investing in Stocks with Little Money if you want tips on how you can get started investing today!
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