The following is a guest post by Barbara Friedberg, editor-in-chief of BarbaraFriedbergPersonalFinance as well as a portfolio manager and MBA professor. She has an MBA in finance and a BS in economics (& an MS in Counseling too). She is passionate about financial literacy and wants to share her knowledge and experience with others.
As I was talking with a fellow personal finance enthusiast yesterday, I realized once again – young people who learn investing basics have a leg up on their peers as well as an unbelievable opportunity for lifetime wealth. This opportunity far surpasses the investing opportunities of their parents, their grandparents, and their elders. In most instances, the elders trump the youth; make more money, have more experience, have better homes & cars, and frequently have less stress.
Then how can it be that the younger folks are in a better position to invest with greater chance of success than those with more years under their belts?
My former MBA professor, Dr. Pat C. frequently espoused the SECRET TO WEALTH: Time in the market.
What the heck does time in the market mean?
Someone offers you a choice:
- A penny on day 1 and doubles the amount every subsequent day for a month.
OR
- At the end of the month you may have $100,000.
Which would you choose?
If you chose option 2, you are like most people, $100,000.00 after one month, how could you go wrong? A penny doubled each day for a month couldn’t possibly compare. Guess what, on day 31, your original penny is now worth $10,737,418.24.
With option 1, on day 14, you have $81.92. By day 18, your money has grown to $1,310.72. After doubling 5 more days, on day 23, your penny is worth $41,943.04. By day 31, that penny has compounded to more than 10 MILLION DOLLARS!
As you grow your original investment, the money you make on top of that investment grows exponentially.
Check out this real life example. After all, no one is going to double your money every day, unfortunately.
Consider these historical long term returns for 2 popular types of investments (asset classes).
Stocks-9%
Bonds-5%
Let’s say you invested $200.00/month in stock funds and $100.00/month in bond funds for 40 years. And assume their future returns were 9%/yr for the stock funds and 5%/year for the bond funds. You would have a total of over $1,000,000.00 at the end of 40 years.
| Amount invested per month | Average Return | Total amount invested | Ending value after 40 years | |
| Stocks | $200.00/month | 9% | $96,000.00 | $936,264.00 |
| Bonds | $100.00/month | 5% | $48,000.00 | $152,617.00 |
| Total- 66% STOCKS 34% BONDS |
$300.00/month | Average combined return 7.64% |
$144,000.00 | $1,088,881.00 |
Of course we all know that historical returns are no guarantee of future results. But consider this question; do you believe the United States and world economies will continue to grow in the future? If so, then contributing to stock (ownership in companies) and bond (loans to companies and governments) mutual funds when you are young and adding to them regularly will likely grow your wealth way beyond your expectations.
We don’t know if the return will be the same as in the past, but it is likely that it will beat out the historical 3% inflation rate.
PRACTICAL APPLICATION: I have no Money, How Can I Start?
With money, as with time, there is usually availability for the important things. You have time for stuff that matters. You have money for what is important. Make a commitment NOW to your future. Start with any amount and increase as time goes on. You won’t miss money taken out of your paycheck before you get your hands on it.
- If your employer offers a retirement plan, sign up. Start out contributing at least enough to get an employer match and more if you are really motivated.
- If you have no retirement account at work, shift money to a discount broker (ie Vanguard, Charles Schwab, or Fidelity) every month.
- Depending on how comfortable with your asset values going up and down (RISK TOLERANCE). You will choose investments weighted more toward stocks (riskier) or more toward bonds (less volatile). For more help on this topic check out my Lazy Investors Guide to Asset Allocation (see below).
- In your investment account, either at work or at a discount brokerage, choose 3 types of funds to start with: A broad based stock index fund which includes stocks from all over the USA of various sizes such as Vanguard Total Stock Market Index (VTSMX). Next choose a broadly diversified international stock index fund like Vanguard International Index Fund (VGTSX). Third, put a percent of your investing dollars in a total bond fund like Vanguard Total Bond Market Index (VBMFX).
- Keep adding to these funds every month in the percentages you are comfortable with. (Stocks, higher risk/higher return; Bonds lower risk/lower return).
You are done! Check your progress every 6 months or so. That’s it!
ACTION STEP:
Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.
Learn about investing by reading my- series MBA Course: Investing and Portfolio Management.
Class 1: Risk vs. Reward
Class 2: Bonds
Class 3: The Lazy Investors Guide to Asset Allocation
Class 4: Get Rich by being Passive
Take charge of your future!
Caveat: This article is for information purposes only and may not be appropriate for your individual situation.
Question from Crystal:
What do you think? Do you do something similar to the above?
That is a great example of the power of compounding returns. I’ll take the penny any day!
Thanks for a great guest post!
Great guest post, Barb! The penny example reminds me of an ancient Chinese proverb about a grain of rice and a chessboard…
@Barbera
Great writeup! Solid advice
@Kevin@InvestItWisely
That old Chinese proverb is one of my favorites!
Another great story that explains compound interest, is the one about how many time do you have to fold paper before it reaches the moon!
Love the penny example. And time is so powerful. Since I can’t go back and change my 18 year old self, I’ve been trying to pass information like this onto my son.
@Rob-I agree, I’m still looking to sign up for the penny the first day and doubling thereafter:)
@Jenny-glad you liked it!
@Kevin-Maybe even the tortoise and the hare apply here?
@Money-Sometimes these stories are the best way to make a point. I’m always attempting to take the “dry” out of finance and investing.
@Jackie-Good idea and good luck. Keep trying—I find the repetition method of instructing offspring has the potential for some results:)
Thanks to all for reading and commenting.
When I was in my early twenties this logic (of investing) was explained to me. I choose to ignore it. When I was in my late twenties another friend repeated this investment logic. I still ignored it. It wasn’t until I turn thirty that I decided to start investing my money.
I think educating young people on investment is a great first step but how do you address the attitude I had (which I think is pretty typical) of, ‘I’ll do it later’?
Hi Molly, That is a GREAT question. Stories and examples make the topic more real. Unfortunately, some individuals need to come to these concepts in their own time. What caused your turn around and influenced you to start investing?
As you wisely pointed out, compound interest only works in the economies that are growing. For a Japanese investor investing in Nikkei 20 years ago would not have worked out.
There is a basic principal behind the concept of compound interest that is key to understanding how real wealth is created. It is the concept of leverage. I don’t mean leverage in the sense of borrowing money to speculate. What I mean is that you invest in assets that are productive – they produce more real value than they consume. Once you have found asset like this, keep on investing and reinvesting and pretty soon you will be wealthy.
This concept also works for love, health, happiness, relationships, etc in addition to money
Hi Arohan, I like the analogy. Understandably, investing in a declining asset won’t grow your wealth. Since we don’t know which assets will grow the most in the future it’s important to spread you investable dollars around and diversify! Thanks for adding to the conversation.
Great post! I’ve been struggling with my own asset allocation. We are in a bit of a strange situation right now where hubby and I’s 401Ks are 100% stocks. We both have pensions that will cover my calculated needs so I currently consider that our “bonds” portion. I am slowly starting to change my mind and looking into diversifying a little more by having a part of our new contributions go into bonds.
Julie, Considering your pension as your “bonds” allocation is reasonable. So much of the asset allocation decision depends upon your risk tolerance and time horizon (when you need to access the invested money). There is no one right answer.
In your stock portion, are you diversified internationally as well as across size of companies (large caps, mid caps, & small caps)?
Depending upon your choices in your retirement account, you can get this type of diversification in 1-2 funds (hopefully index funds).
Good luck and check out my MBA series for more information.
Interesting question there! The best way to make worth our time is on a business. How can we do to make the business profitable? Answer: Planning, choosing the correct audience and the correct market.
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