By Eric Tashlein
Your Finances
Eric Tashlein
If you are the parent of a teenager or young adult, you know how difficult it can be to convince them to set aside money for the future. It’s understandable that young people tend to spend all their money – in their minds they have all the time in the world and can start saving later.
How can you get them to understand that “later” never comes? One way is to show them concrete examples of the power of compound interest combined with the wisdom of starting early on the road to financial security. The Investment Company Institute’s Education Foundation recently published a series of examples that I am presenting here for you to share with the young people in your life.
Start with a simple one: If you invest $100 and earn 5 percent interest, you will have $105 at the end of a year. If you spend the $5 of earnings on video games and then reinvest the $100, and do the same thing for 20 years, you will end up with your original $100 – you spent the $100 you earned.
However, if you invest $100 at 5 percent interest and reinvest your $5 earnings into the account, after a year you’ll have $105.25, an extra quarter. Over two decades, the power of compound interest will turn that quarter into $65. You will also have the other $100 you earned, since you never spent your $5 bonus, so you’ll have $265 in cash rather than $100. Multiply that by thousands of dollars.
Now let’s look at the importance of starting early. Compare two investors who make a $1,000 investment. Investor 1 leaves the investment to grow for 40 years. Investor 2 starts 20 years after Investor 1 and lets the money grow for 20 years (this example does not take into account taxes or inflation and assumes a 7 percent annual rate of return).
At the retirement finish line, Investor 1 will have $14,975 while Investor 2 will have just $3,870, about one fourth of Investor 1’s total.
These are simplistic examples that don’t take into account the fact that most investors continue to contribute to their investment accounts, through payroll deductions or other automatic systems. So, let’s look at what happens when you continue to fuel your investment portfolio.
Three people invest $1,000 every year until they reach age 65. Investor A begins at age 25, Investor B begins at age 35, and Investor C begins at age 45. Over that time, Investor A puts in $40,000, Investor B contributes $30,000, and Investor C puts in $20,000.
At the retirement finish line, Investor A will have more than $200,000, double the roughly $100,000 earned by Investor B and four times the nearly $50,000 earned by Investor C.
If the person who starts late contributes more money, he or she can partly catch up, but will likely still lag behind the person who started earlier, because the more time you give compound interest to work, the better it is for your eventual nest egg.
Eric Tashlein is a Certified Financial Planner professional™ and founding Principal of Connecticut Capital Management Group, LLC, 2 Schooner Lane, Suite 1-12, in Milford. He can be reached at 203-877-1520 or through connecticutcapital.com. This is for informational purposes only and should not be construed as personalized investment advice or legal/tax advice.