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- Herausgeber: John Wiley & Sons
- Kategorie: Fachliteratur
- Sprache: Englisch
Simplify your financial life and ensure financial success into the future Feeling paralyzed by the overwhelming number of complex decisions you need to make with your money? You don't need to be an expert to achieve financial freedom. You just need a framework that makes the right choices simple and easy to make. Making Money Simple provides that much-needed process so you can get on the right track to long-term financial security. This valuable resource provides a solid foundation for all the nuanced personal finance decisions you need to make as you go through your career, hit major life milestones, and look to grow wealth. It's a blueprint for financial achievement--even through tough-to-navigate situations where there are no clear-cut rules. After you read Making Money Simple, you'll be able to create your personal plan for success using proven wealth management methods and real-world financial strategies. From basic financial principles to advanced investing techniques, you'll get comprehensive coverage of fundamental financial topics with easy-to-follow advice from author Peter Lazaroff, who draws from his expertise as the Chief Investment Officer of a multi-billion-dollar wealth management firm to give you the tools you need to simplify your financial situation and make the right moves at every opportunity. Getting your finances in order doesn't have to be hard. It doesn't require fancy, convoluted investment strategies. Nor does it require keeping track of detailed spreadsheets. You just need this step-by-step process to get your financial house in order and keep it that way forever. It doesn't matter what your specific situation is. We all need to understand our money--and what to do with it. Making Money Simple shows you how to: * Develop clear financial goals and plan for your future * Understand the three crucial elements of building a strong financial house * Implement effective investment strategies to grow your wealth and avoid costly mistakes * Learn ten smart questions to ask when hiring financial professionals For those seeking to secure a solid financial future, Making Money Simple: A Complete Guide to Getting Your Financial House in Order and Keeping It That Way Forever is the roadmap to get you there.
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Veröffentlichungsjahr: 2019
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Table of Contents
Cover
Introduction
THE MOST POWERFUL TOOL IN YOUR FINANCIAL TOOLBOX
ENVISION WHAT YOU WANT, THEN CREATE A PLAN TO GET THERE
IT'S NOT EASY, BUT IT DOESN'T HAVE TO BE HARD
THE GUIDANCE YOU NEED FOR THE FINANCIAL SUCCESS YOU WANT
NOTES
CHAPTER ONE: The Power of Time and Compounding
THE POWER OF COMPOUND INTEREST
MAKE COMPOUND INTEREST WORK FOR YOU: SAVE EARLY AND SAVE OFTEN
THE DARK SIDE OF COMPOUNDING
SMALL DECISIONS AND GOOD HABITS LEAD TO BIG RESULTS
NOTES
CHAPTER TWO: Where Do You Want to Go?
THE IMPORTANCE OF WRITING OUT YOUR GOALS
PRIORITIZE YOUR GOALS (AND START WITH THESE CRITICAL TWO)
WHERE DOES PAYING DOWN DEBT FIT INTO YOUR FINANCIAL PRIORITIES?
GETTING THE MOST OUT OF YOUR SPENDING
NOTES
CHAPTER THREE: Where Are You Today?
UNDERSTANDING YOUR CASH FLOW
SPENDING TOO MUCH? HERE'S WHAT TO DO
SIMPLE CHANGES FOR BIG SAVINGS
IT'S TIME TO START YOUR JOURNEY
NOTE
CHAPTER FOUR: Creating a System for Financial Success
CREATE A BUDGET THAT ACTUALLY WORKS
HOW TO AUTOMATE INCOME, EXPENSES, AND INVESTMENTS
DEALING WITH LIFESTYLE CREEP
GET YOUR FINANCIAL HOUSE IN ORDER AND KEEP IT THAT WAY FOREVER USING AUTOMATION AND TECHNOLOGY
NOTES
CHAPTER FIVE: Your Introduction to Investing
HOW AVERAGE INVESTORS SABOTAGE THEMSELVES
WHY YOU MUST AVOID PERFORMANCE CHASING
THE IMPACT OF INVESTMENT FEES
HOW TO CREATE LONG-TERM FINANCIAL SUCCESS WITH YOUR INVESTMENTS
NOTES
CHAPTER SIX: Harnessing the Power of Markets
BACK TO BASICS: PRICE AND THE INFLUENCE OF SUPPLY AND DEMAND
THE COLLECTIVE KNOWLEDGE OF FINANCIAL MARKETS
ACTIVE VERSUS PASSIVE INVESTMENT MANAGEMENT: WHICH WINS?
HARNESS THE POWER OF MARKETS
NOTES
CHAPTER SEVEN: Building a Portfolio to Meet Your Goals
BALANCING THE RISK AND RETURN OF DIFFERENT ASSET CLASSES
CHOOSING THE RIGHT ASSET ALLOCATION FOR YOUR GOALS
LOOKING AT DIVERSIFICATION WITHIN YOUR ASSET ALLOCATION
INTRODUCE REBALANCING INTO THE MIX
NOTE
CHAPTER EIGHT: How and Where to Invest Your Savings
GET STARTED WITH DOLLAR COST AVERAGING
WHAT TO DO WHEN YOU NEED TO INVEST A LUMP SUM OF CASH
TIME IS MORE IMPORTANT THAN TIMING
FOCUS ON YOUR SAVINGS RATE, NOT YOUR RATE OF RETURN
REDUCING YOUR TAX BILL TO MAXIMIZE YOUR INVESTMENT RETURN
NOTES
CHAPTER NINE: Facing the Realities of Market Downturns
LEARN HOW TO HANDLE MARKET VOLATILITY OVER THE LONG TERM
FIGHT BAD INVESTOR BEHAVIOR WITH GOALS-BASED INVESTING
TESTING YOUR PROBABILITY OF SUCCESS
NOTES
CHAPTER TEN: Family Finances
GETTING MARRIED AND COMBINING FINANCES
WHAT TO EXPECT (WITH YOUR FINANCES) WHEN YOU'RE EXPECTING
SAVING FOR YOUR CHILD'S COLLEGE EDUCATION
HOW TO MAKE GOOD USE OF A 529 PLAN
BUYING A HOME
NOTES
CHAPTER ELEVEN: Big Financial Decisions at Critical Junctions in Life
WHY YOU NEED AN ESTATE PLAN (NO, THEY'RE NOT “JUST FOR REALLY RICH PEOPLE”)
UNDERSTANDING LIFE INSURANCE: WHAT IT IS, WHY YOU NEED IT, AND HOW MUCH YOU NEED
PROTECT YOUR MOST IMPORTANT ASSET WITH DISABILITY INSURANCE
BUILDING A COMPREHENSIVE FINANCIAL PLAN
NOTES
CHAPTER TWELVE: How to Create Your Own Team of Professionals to Help You Succeed
NOT ALL FINANCIAL PLANNERS ARE CREATED EQUAL: WHAT MAKES A “REAL” FINANCIAL PLANNER
HOW TO CHOOSE AN ADVISOR
USING A ROBO ADVISOR
WHO ELSE DO YOU NEED ON YOUR TEAM?
NOTES
Conclusion: Building a System for Financial Success
PUTTING INFORMATION AND MOTIVATION TO WORK WITH ACTIONABLE SYSTEMS
WORKSHEETS AND STEP-BY-STEP INSTRUCTIONS TO ACHIEVING FINANCIAL SUCCESS
ADDITIONAL RESOURCES
YOUR FREE SUBSCRIPTION TO BRIGHTPLAN
About the Author
Quiz: Is Your Financial House in Order?
Index
End User License Agreement
List of Illustrations
Chapter 1
FIGURE 1.1
THE THICKNESS OF A FOLDED PIECE OF PAPER
FIGURE 1.2 GROWTH OF $10,000 INVESTMENT WITH AN 8 PERCENT RETURN: INITIAL INV...
FIGURE 1.4 GROWTH OF $10,000 INVESTMENT WITH AN 8 PERCENT RETURN: CHANGES IN ...
Chapter 2
FIGURE 2.1
GOAL PLANNING WORKSHEET
FIGURE 2.2 SAMPLE SHORT-TERM GOALS, COMPLETION DATES, AND EXPECTED COSTS...
Chapter 3
FIGURE 3.1
SAMPLE NET WORTH WORKSHEET
FIGURE 3.2
SAMPLE CASH FLOW WORKSHEET
Chapter 4
FIGURE 4.1 SAMPLE SHORT-TERM GOALS, COMPLETION DATES, AND EXPECTED COSTS...
FIGURE 4.2
HOW TO AUTOMATE YOUR INCOME, EXPENSES, AND INVESTMENTS
Chapter 5
FIGURE 5.1 TOTAL RETURN ON HYPOTHETICAL $1 MILLION INVESTMENT OVER 10 YEARS ...
FIGURE 5.2
THE EMOTIONAL INVESTMENT CYCLE
FIGURE 5.3 MONEY FLOWING IN AND OUT OF U.S. STOCK FUNDS COMPARED TO THE PRIOR...
FIGURE 5.4
TOTAL RETURNS OF DIFFERENT ASSET CLASSES SINCE
2000
FIGURE 5.5 THE IMPACT OF EXPENSE RATIO ON A $1 MILLION PORTFOLIO WITH AN 8 PE...
Chapter 6
FIGURE 6.1 ACTIVE PUBLIC STOCK FUNDS THAT FAILED TO BEAT THE INDEX (15 YEARS...
FIGURE 6.2 ACTIVE BOND FUNDS THAT FAILED TO BEAT THE INDEX (15 YEARS AS OF DE...
FIGURE 6.3 SUBSEQUENT PERFORMANCE OF TOP 25 PERCENT OF U.S. STOCK FUNDS (AS O...
Chapter 7
FIGURE 7.2 BEST, WORST, AND AVERAGE TOTAL RETURNS FOR VARIOUS ALLOCATIONS OF ST...
FIGURE 7.3 CAPITAL MARKETS HAVE REWARDED LONG-TERM INVESTORS: MONTHLY GROWTH OF...
FIGURE 7.5 U.S.
STOCK AND BOND DOWNTURNS
(1990–2017)
FIGURE 7.6 PERCENTAGE OF 12-MONTH PERIODS WITH NEGATIVE RETURNS FOR STOCKS AND ...
FIGURE 7.7
COMBINING INVESTMENTS THAT BEHAVE DIFFERENTLY REDUCES VOLATILITY
FIGURE 7.9 ANNUAL AND FULL PERIOD PERFORMANCE RANKED FROM HIGHEST TO LOWEST TOT...
FIGURE 7.10 LONG-TERM PERFORMANCE OF AN ANNUALLY REBALANCED PORTFOLIO VERSUS A ...
Chapter 8
FIGURE 8.7
USING TRADITIONAL AND ROTH ACCOUNTS AT DIFFERENT STAGES OF LIFE
Chapter 9
FIGURE 9.2 WORST INTRA-YEAR LOSSES FOR THE S&P 500 (1926–2017)...
FIGURE 9.3
RETURNS ARE LESS VOLATILE OVER LONG PERIODS OF TIME
FIGURE 9.4 U.S.
BULL AND BEAR MARKETS
(1903–2017)
Chapter 11
FIGURE 11.1
DIFFERENCES BETWEEN USING A WILL AND A TRUST
Chapter 12
FIGURE 12.2
ROBO VERSUS HYBRID VERSUS TRADITIONAL ADVISORS
Guide
Cover
Table of Contents
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Making Money Simple
The Complete Guide to Getting Your Financial House in Order and Keeping It That Way Forever
Peter Lazaroff
Copyright © 2019 by Peter Lazaroff
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.
Published simultaneously in Canada.
No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at www.wiley.com/go/permissions.
Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.
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ISBN 978-1-119-53787-8 (Hardcover)ISBN 978-1-119-53782-3 (ePDF)ISBN 978-1-119-53785-4 (ePub)
Cover Design: WileyCover Images: background © in-future/Getty Images, money house © ValentynVolkov/Getty Images
Introduction
My first distinct memory of money was during a night out with my family at a local pizza shop. I don't remember how old I was, but I'd guess no older than six or seven. The restaurant had a jukebox and I asked my dad for money to pick out a song. Instead of handing over some change, my dad asked, “Is it worth your money?”
I told him no and he responded, “Then it's not worth mine.”
The next time we went to that restaurant, I found myself eyeing the jukebox again. And again, I asked my dad for some money to pick songs on the jukebox. My dad asked the same question: “Is it worth your money?”
This time, thinking I was clever, I said yes. Then my dad said, “Great, then you can spend your own.”
This lesson in the value of money is one of my most vivid memories as a child. My parents generally did the right thing with money: they didn't spend more than they earned and they were good savers. But beyond that, they didn't sit down and teach me about money. Money wasn't an off-limits topic, but it also wasn't a focal point of our routine family dinners. My perception is this isn't uncommon among most families.
So when do we get an opportunity to learn about money?
We don't learn about money basics in elementary school. We don't teach high school seniors how to budget or pay bills. Most college graduates don't take a course in personal finance or receive an unbiased education in the right way to invest money. It's even more unlikely they took a deep dive into financial planning topics like how to plan for retirement, buy a home, save for a child's education, or any other situations in life that require an understanding of how to manage money.
In school, you are given a lesson, then a test. In life, you are given a test and then you learn a lesson—and money lessons can be expensive.
I was fortunate in that I took an interest in basic personal finance as a teenager. It started when my grandmother gave me a share of Nike stock for my 12th birthday. I remember sitting in my parents' living room near the Christmas tree (I have a December birthday) and thinking this gift was boring relative to the video games I also received.
But then we started talking about the mechanics of investing and how the share of stock meant I had an ownership stake in one of my favorite brands. Maybe it was the fact that Nike seemed to be worth more every time I checked the newspaper or maybe it was the dividend checks I received for doing no work at all, but it didn't take long for me to be hooked on the idea of investing.
A few years after that birthday, my parents took me to the bookstore to buy an investment book geared toward young adults. The first one I picked out was Peter Lynch's Learn to Earn: A Beginner's Guide to the Basics of Investing and Business. This book is arguably the most influential book I've ever read. Not necessarily because it was the best book, but it was the source that turned an interest into an obsession.1
In high school, I asked my parents to subscribe to the Wall Street Journal so that I could read the Markets section. In college, I devoured books and periodicals on investing, personal finance, and economics. My parents were thrilled because I didn't like reading throughout most of my childhood. But reading about finance was different. Making good money decisions fascinated me. It was like solving a puzzle. There was a way to “win,” which appealed to my competitive personality. And while I deeply regret not reading more of my assigned materials in high school, to this day I can't figure out why some of these financial issues weren't being taught in the classroom, too.
What I read in those investment books stuck with me, and even before I reached adulthood, I was laser focused on making the right decisions with my money. As a kid, I worked as a referee for youth basketball games in the winter. In the summer, I worked as a camp counselor on the weekdays and then a car wash and restaurant on the weekends. I contributed the money I made from these seasonal jobs to a Roth IRA even before I went off to college. That early start with finances and investing set me up for success year after year in my adult life.
I didn't start with a lot of money. I didn't use any complicated strategies in an effort to beat the market. From the ages of 13 to 18, I worked and earned a little cash. I read some basic information and consumed enough material to stay interested and engaged. And I invested in the stock market.
There was no magic involved, no trademarked secrets. Starting early and keeping things simple laid the groundwork for my financial success in adulthood. Regardless of when you start, you can use this blueprint for success, too.
THE MOST POWERFUL TOOL IN YOUR FINANCIAL TOOLBOX
“I just want to make sure I'm doing the right thing.”
That's what most people want when they start asking questions about their finances. Maybe you are just finishing college or graduate school. Maybe you just started earning enough to begin start saving more or aggressively paying down debt. Maybe you just had a child and need to understand how to manage your increased expenses (along with a whole new set of child-centric financial goals). Maybe you inherited money and want to ensure you make the most of it.
Regardless of your specific situation, we all need to understand our money and what to do with it. That's not easy to do on your own. The earlier I can reach a person in their life, the bigger the impact I can make on their financial success. That's not because I'm going to help them earn a few extra percent on their investments. It's because I'm going to leverage the power of compounding by putting systems and processes in place that encourage good financial behaviors.
Financial success isn't magic; it's engineering. And time is the most powerful tool in your financial toolbox. Time allows compound interest to grow wealth exponentially. Time allows basic investment theory to hold true. Time and thoughtful planning allow you to make your hard-earned dollars support the life you want to live.
For most of my career, I've been known as an investment expert. This reputation was built by helping countless individuals and institutions as a financial advisor by distilling complicated investment issues into understandable information. Along the way, I've also written monthly articles for the Wall Street Journal and Forbes while sharing my insights across a wide spectrum of national media outlets. Today I'm the Chief Investment Officer at Plancorp, which manages billions of dollars for clients across the country. I'm also the Chief Investment Officer of BrightPlan, a digital advisor designed to democratize fiduciary advice.
Despite those credentials, this isn't an investment book. Yes, investments are a very important part of a financial plan and we will talk about the fundamentals here. But it's so important to understand that fancy, convoluted investment strategies don't ultimately determine financial success. What this book will do is take you step by step through the process of getting your financial house in order and keeping it that way forever.
ENVISION WHAT YOU WANT, THEN CREATE A PLAN TO GET THERE
All too often, people make money decisions without the end goal in mind. They focus on the near term instead. What I recommend is starting with questions like these: What is your perfect money situation? How much would you need to be happy?
I'm not asking for a dollar amount. Picture your life with money never being a concern. For me, that means not worrying about whether each and every purchase is worth it. I order what I want at a restaurant. I take a vacation to the destination of my choice as time and logistics dictate. I live in the house that I want. I want to maintain my existing lifestyle and the comforts that I've worked hard for throughout my career. This is what the perfect money situation looks like to me.
What does financial success look like to you? We'll outline the steps you need to take in order to achieve your perfect money life.
IT'S NOT EASY, BUT IT DOESN'T HAVE TO BE HARD
There are very few things that people delay more than taking steps to improve their finances. It's cliché, but I frequently compare getting financially fit to getting physically fit. We all know we should eat healthily and exercise regularly, and yet most people don't abide by these simple rules. Perhaps the lack of immediate results is what discourages people from going to the gym five times a week or avoiding late-night snacks. For others, maybe it comes down to struggling to find the time or maintain the discipline required to live a healthy lifestyle.
Improvements to your health aren't achieved after a single 30-minute workout or a week of healthy eating. But the amazing thing about money is that you can permanently improve your finances with a single 30-minute activity such as automating your finances or completing one of the worksheets provided in this book (all worksheets can be downloaded at peterlazaroff.com/worksheets). It sounds easy enough, but there are some common obstacles people face when making these simple improvements in their life.
For starters, the number of choices and deciding where to start tends to paralyze people. For example, research shows that employee participation in 401(k) plans decreases when more investment options are available.2 But this phenomenon isn't limited to finance alone. It's part of human nature.
One of my favorite examples of this comes from a study of shoppers sampling jams at an upscale food market. One day, shoppers saw a display table with 24 varieties of gourmet jam and received a $1 off coupon for sampling any jam. On another day, shoppers received the same coupon for $1 off any jam, but only six varieties of the jam were on display. When the time came to purchase, people who saw the smaller display were ten times likelier to buy jam than the people who saw the larger display.3
In personal finance, the number of choices and complexity of each underlying option makes it difficult to get started. The purpose of this book is to give you a clear starting point, focus only on the most important decisions to make, and create a saving system that quietly nudges your finances in the right direction without regular effort on your part.
A second problem people face with personal finance is a lack of clear-cut rules for financial success. Financial success, and the path to achieving it, is different for everyone. There isn't a perfect fix for this issue, but this book aims to provide tools that apply to everyone and form a framework for thinking about decisions that are more personal.
A third problem is that the human brain isn't hardwired to make optimal money decisions. Our cognitive and emotional biases create tremendous barriers to financial success. I've included lots of examples and discussions around these biases to help you become more aware of the mental errors we make, and I've also provided strategies to combat them.
Finally, and perhaps most importantly, people get discouraged by the speed of their progress. When you make good financial decisions, it takes time to see the impact. Much like physical exercise, you won't have a six-pack after a single trip to the gym. But unlike exercise, which requires constant action over a long period of time, improving a single area of your personal finances takes only 30 minutes and the benefits can last a lifetime. You just need to allow them time to work.
THE GUIDANCE YOU NEED FOR THE FINANCIAL SUCCESS YOU WANT
The financial industry doesn't always have your best interests at heart. You may be sold different products and solutions based on the person sitting across the table. More and more people are promising to act as fiduciaries—the fiduciary standard requires that an advisor put the client's interest first—but they aren't being policed the way they should be.4 I've worked as a fiduciary my entire career. The information in this book is derived from the same advice I give to clients at Plancorp and BrightPlan. The tools and resources are the same ones my wife and I use. Now I want to teach you the things that matter most in driving your financial success.
Innovations in the world of finance will continue to shape the way we manage our financial lives, but good financial advice will never change. If you read this book from start to finish, you will have a game plan for setting and reaching your life goals with minimal ongoing effort. But before we do any of that, your journey starts with learning how to leverage the most powerful tool at your disposal: time.
NOTES
1
You can find investment and personal finance book recommendations in the Conclusion.
2
Sheena S. Iyengar, Gur Huberman, and Gur Jiang, “How Much Choice Is Too Much? Contributions to 401(k) Retirement Plans,”
Pension Design and Structure: New Lessons from Behavioral Finance,
Chapter 5
, Oxford Scholarship Online, January 2005.
3
Sheena S. Iyengar and Mark R. Lepper, “When Choice Is Demotivating: Can One Desire Too Much of a Good Thing?”
Journal of Personality and Social Psychology
79, no. 6 (2000), 995–1006.
4
The fiduciary standard creates a legal obligation for financial advisors to put the interests of clients before their own. In addition, anyone selling investment products or providing investment advice to the public must disclose any conflicts of interest that might compromise that fiduciary duty. Every person working with an investment professional should get him or her to commit in writing to act as a fiduciary at all times.
CHAPTER ONEThe Power of Time and Compounding
The most powerful tool you have for reaching your goals is time.
Time mixed with the power of compounding is the most potent combination for wealth creation. Compound interest allows you to grow wealth faster by earning a return on your past returns. This isn't a linear relationship; it's exponential, and that power is the most underappreciated component of a financial plan. The human brain simply isn't good at visualizing exponential things, which may explain why it's so difficult to fully appreciate a plan that fully leverages the power of compounding.
Let's try to fix that.
Imagine you take a sheet of standard printer paper with a thickness of 0.1 mm. Fold it over once and it gets twice as thick. Fold it again and you've doubled the thickness of the paper again; two folds make the paper four times as thick. Fold it a third time and now the paper is eight times as thick. If you could fold that piece of paper 50 times, the paper would stretch 95 million miles or approximately the distance from Earth to the sun. At 100 folds, it matches the radius of the universe (see Figure 1.1).
FIGURE 1.1THETHICKNESS OF AFOLDEDPIECE OFPAPER
Unfortunately, it isn't possible to fold a piece of paper more than eight times (try, I dare you). But the underlying math of repeatedly doubling the thickness of paper is exciting when we apply the same exponential growth to your savings.
THE POWER OF COMPOUND INTEREST
How many times can you double your money during your lifetime? That depends on your age and rate of return. With these inputs, we can use a rule of thumb known as “The Rule of 72.” Simply assume a reasonable rate of return for planning purposes (between 7 percent and 9 percent over a multidecade time period) and divide 72 by that rate. This calculates the period of time it would take for your money to double.1
To make the math nice and even, let's say we earn an 8 percent return on your money. According to the Rule of 72, it takes nine years to double your money (72 ÷ 8 = 9). Ready for the compounding part? (See Figure 1.2.)
FIGURE 1.2GROWTH OF $10,000 INVESTMENT WITH AN 8 PERCENTRETURN: INITIALINVESTMENT VERSUSCUMULATIVECOMPOUNDINTEREST
Let's start with $10,000 and continue to assume we earn a return of 8 percent. After nine years, the Rule of 72 tells us we will have $20,000. It should seem obvious that the $20,000 then takes another nine years to double, so we will have $40,000 after 18 years. As we will see in a moment, the earnings on interest becomes disproportionately larger than the earnings on the initial investment.
To see how good planning can maximize the benefit of compound interest, we can draw from Benjamin Franklin's financial plan. At his death, Franklin's will left 1,000 pounds sterling (then worth about $9,000) to his adopted home of Philadelphia and his native city, Boston.2
Franklin wanted trustees to loan the money to apprentices, much in the same way he received assistance early in his career. His will also stipulated that the interest collected from the loans should stay invested so it could compound over time. After 100 years, both cities could withdraw 75 percent of the funds to use for infrastructure projects that would improve the quality of life for those living in these cities like bridges, roads, water systems, and public buildings. Then in another 100 years, the cities could withdraw the remaining balance for additional infrastructure and city betterment projects.
Franklin estimated a 5 percent annual rate of returns from the loans. It turned out to be 4 percent. He was off by one percentage point, but remember that financial success depends less on marginally higher returns than it does on saving and time. This case serves as a perfect example of this phenomenon.
The cities made their first withdrawals in 1890. The fund grew from Franklin's initial contribution of $9,000 to $500,000 over a period of 100 years (that's about $13 million in today's dollars). When the cities could make their second withdrawal in 1990, they gained access to another $6.5 million (or $12 million in today's dollars). Franklin understood the power of compounding. He knew that good planning and time were the essential ingredients to having it work in your favor.
You probably won't get to work with a 100-year time horizon, but you will get several decades to allow your investments to earn compound returns if you start saving now. The way Franklin structured his will provides a great illustration of how thoughtful planning and time can best capture the power of compounding. The more time you have, the more your wealth benefits from this compounding effect. Once you create a well-thought-out financial plan that focuses on maximizing your wealth as a means to meet your goals, you can sit back and let time do its thing.
MAKE COMPOUND INTEREST WORK FOR YOU: SAVE EARLY AND SAVE OFTEN
The most important rule in planning for retirement is to save early and often. How early and how often? Start as soon as you begin earning an income and save some of every paycheck. If you haven't been saving, then the time to start is now. Saving early gives you what we've just seen is critical to leveraging the power of compounding: a long time horizon.
Compound interest is like rolling a snowball downhill. As it rolls along, it collects more snow with each rotation. The further it rolls, the more mass it can exponentially gain. That's exactly how Benjamin Franklin's initial $9,000 contribution turned into $500,000 over 100 years with a 4 percent rate of return. It's also why Warren Buffett says, “Life is like a snowball. The important thing is finding wet snow and a long hill.” The wet snow is the interest you reinvest to pick up even more interest as you roll along. The long hill is the multiple decades you give yourself if you start saving early.
Figure 1.3
