Power of compounding! It is such a powerful tool that Albert Einstein once called it the most important invention in all of human history. But if it’s so awesome, I wondered, why do so few of us take full advantage of it?
Below insightful excerpt on the power of compounding is from one of my favorite books ‘MONEY Master the Game: 7 Simple Steps to Financial Freedom’ by Tony Robbins.
#1 Story of Two Brothers
To illustrate the exponential power of compounding, Burton Gordon Malkiel shared the story of twin brothers William and James, with investment strategies that couldn’t have been more different. Malkiel (born August 28, 1932) is an American economist and writer most noted for his classic finance book A Random Walk Down Wall Street.
The story supposes that William and James have just turned 65—the traditional retirement age. William got a jump-start on his brother, opening a retirement account at the age of 20 and investing $4,000 annually for the next 20 years. At 40, he stopped funding the account but left the money to grow in a tax-free environment at the rate of 10% each year.
James didn’t start saving for retirement until the ripe old age of 40, just as his brother William stopped making his own contributions. Like his brother, James invested $4,000 annually, also with a 10% return, tax-free, but he kept at it until he was 65—25 years in all.
In sum, William, the early starter, invested a total of $80,000 ($4,000 per year × 20 years at 10%), while James, the late bloomer, invested $100,000 ($4,000 per year × 25 years at 10%).
Difference…It’s 600% More!
So which brother had more money in his account at the age of retirement?
Tony knew where Malkiel was going with this, but he told the story with such joy and passion that it’s like he was sharing it for the very first time. The answer, of course, was the brother who’d started sooner and invested the least money. How much more did he have in his account? Get this: 600% more!
In Malkiel’s example, it was William, the brother who’d gotten the early start and stopped saving before his brother had even begun, who ended up with almost $2.5 million. And it was James, who’d saved all the way until the age of 65, who had less than $400,000. That’s a gap of over $2 million! All because William was able to tap into the awesome power of compounding for an additional 20 years, giving him an insurmountable edge—and saddling him with the family dinner checks for the rest of his life.
#2 Story of Benjamin Franklin’s $1,000
Not convinced that compound interest, over time, is the only sure way to grow your seed of money into the bumper crop of financial security you’ll need to meet your future needs?
Malkiel shared another favorite story to bring home his point—and this one’s from our history books. When Benjamin Franklin died in 1790, he left about $1,000 each to the cities of Boston and Philadelphia. His gift came with some strings attached: specifically, the money was to be invested and could not be touched for 100 years. At that point, each city could withdraw up to $500,000 for designated public works projects. Any remaining money in the account could not be touched for another 100 years. Finally, 200 years after Franklin’s death, a period of time that had seen stocks grow at an average compounded rate of 8%, each city would receive the balance—which in 1990 amounted to approximately $6.5 million. (Image Credit Wikipedia)
Imagine that $1,000 grows to $6.5 million, with no money added over all those years. How did it grow? Through the power of compounding! Yes, 200 years is a long, long time—but a 3,000% rate of return can be worth the wait.
Malkiel’s examples show us what we already know in our hearts to be true: that for most of us, our earned income will never bridge the gap between where we are and where we really want to be. Because earned income can never compare to the power of compounding!
#3 Story of an Ordinary Employee
Theodore Johnson, whose first job was with the newly formed United Parcel Service in 1924, worked hard and moved his way up in the company. He never made more than $14,000 a year, but here’s the magic formula: he set aside 20% of every paycheck he received and every Christmas bonus, and put it into company stock. He had a number in his head, a percentage of income he believed he needed to save for his family—just as you will by the end of this chapter—and he committed to it. Through stock splits and good old-fashioned patience, Theodore Johnson eventually saw the value of his UPS stock soar to over $70 million by the time he was 90 years old.
#4 Story of a Sixth-Grade Educated Women
Have you heard the story of Oseola McCarty from Hattiesburg, Mississippi—a hardworking woman with just a sixth-grade education who toiled for 75 years washing and ironing clothes? She lived simply and was always careful to set aside a portion of her earnings. “I put it in savings,” she explained of her investment philosophy. “I never would take any of it out. And I just put it in. It just accumulated.” (Image Credit Wikipedia)
Oh, boy, did this woman’s money accumulate. At 87 years old, McCarty made national news when she donated $150,000 to the University of Southern Mississippi to start a scholarship fund. She became The University of Southern Mississippi’s (USM) most famous benefactor. She worked hard and knew enough to see that her money worked hard, too.
“I want to help somebody’s child go to college,” she said—and she was able to do just that, on the back of her good diligence. There was even a little leftover for a small luxury item: she bought an air conditioner for her house.
Just Do This!
I was not aware of this compounding power, at least 8-9 years back. But at the same time, I continued doing investments. Today I could realize the power of compounding.
I was sharing the above concept with one of my colleagues, who is doing regular investment. I also explained to him the power of compounding with mathematical formulas. He was fascinated by seeing this as there was a tremendous difference in net amount by changing the investment amounts and rate of return. Within three days, he had double his yearly investment amount. I liked it!
Remember, when your money starts earning money for you, you are heading towards financial freedom.
“Money makes money. And the money that money makes, makes money.”- Benjamin Franklin