Compounding Your Success
Posted by Gail | Filed under Investing
I’ve received quite a few letters recently challenging the numbers I project for couples in terms of how much they’ll have at retirement. I’m not really surprised. Most people don’t understand the concept of “compounding” or we’d have way more savers in this world.
The Magic of Compounding makes the money you invest work harder to earn you more money. In Investor-Speak, “Compounding is the process of generating a return on an asset’s reinvested earnings.”
Compounding can be thwarted. People have no patience. They also have a hard time deferring gratification. So if Susie earns $20 in interest on an investment, and sees it as “found money,” she’ll rush right out and spend it. Susie’s justification: I didn’t have to do anything for that money so it’s like a gift. By spending it, Susie just robbed herself of the Magic of Compounding.
Let’s say Susie didn’t spend her interest. Nope. Susie had a plan. She invested $15,000 last year at 5.5%, so now she has $15,825. Rather than blow the $825 her investment has earned, Susie decides to keep it invested for another year. If she earns the same rate of 5.5%, her investment will grow to $16,695 by the end of the second year.
Because Susie reinvested her return, it works with the original investment to earn more return. $65 more. Peanuts! you say. Hardly worth the effort. What effort? Susie didn’t have to lift a finger to earn that $65. On top of which, that $65 now has the opportunity to earn even more return. In another year, Susie’s $15,000 investment will be worth $17,614. That’s the magic of compounding in action: return earning return on return and so on.
Susie has a twin sister, Sami. When Susie was 25 she invested $15,000 at 5.5%, compounding annually. When Susie is 50, her $15,000 will have grown to a whopping $57,200.89. Sami waited until 35 to stick her $15,000 away at the same rate of return. When Sami is 50, her $15,000 will have grown to $33,487.15. Susie and Sami invest exactly the same amount of money, but Susie ends up with $23,713.74 more because she gave her investment more time to grow. Violá: the Magic of Compounding.
How often your investment compounds will also affect how much money you end up with. If your investment compounds annually, the return is added to the pool once a year. If it compounds semi-annually, it’s added twice a year, allowing the return you’ve earned to go to work more quickly on your behalf. An investment with a 5.5% rate of return will have an Annual Percentage Yield (APY) of 5.614% if compounded quarterly, 5.641% if compounded monthly and 5.654% if compounded daily… which is one reason the Daily Interest Savings Account became pretty popular with some folks.
You can use the Rule of 72 to see just how different rates of return affect your annual compounding return. A return of 5.5% compounded means your investment will double every 13 years (72 divided by 5.5). If you manage to earn 8% on your money, your investment will double every 9 years. Earn only 2%, and it’ll take 36 years for your money to double.
Rumour has it that for every ten years you delay before starting to save for retirement, you’ll need to save three times as much each month to catch up. I haven’t done the math myself – I’m already convinced – but it’s worth noting because it means you can save a little starting in your twenties, or pony up with plenty more if you wait a couple of decades to begin planning for the future.
Yes, I know it’s easy to put off investing to a time when you have “enough” money to stick some away. Truth is, you have to make saving a priority. And by putting a little away regularly from when you’re in your early 20’s, you’ll have more in the long run, and you want have to pinch pennies to come up with a nest-egg.
Note: Before y’all start writing to me to say…”5.5%, where’d you get 5.5%?” I’ll tell you that I have several investments within my RRSP that are paying 5.5% right now. These aren’t investments I made yesterday, and when I made them 5.5% seemed like a pittance, but in today’s world, they’re looking pretty good. I also have some investments that are deeply under water. And I have not stopped investing. This year’s RRSP contribution when right into the index. Yes it’s still bouncing around a lot, but if they can just shoot all the short-sellers, maybe the market has half a chance of recovering!
March 4, 2009 at 9:43 am
Gail,
However, guess where my this year’s RRSP contribution went? Into an index fund as they are a bargain right now! LOL
I hear you about the short sellers. Most of mine has been taken to the dumpster. Tried to realign my RRSP last year as I was turning 46 and the very nice banking lady said I didn’t need to be out of equities yet as I had 25 years to go. I’ll now have to make about 150% between now and then just to break even.
By the way I started in my early 20s and maxed until I quit work to stay home with the kids. Hubby did some spousals for me. Mutual funds are NOT the way to go. They eat the profits for lunch with there MERs and most of them did very lousy over the years. It’s hard to compound when they tank everytime the market takes a nose dive.
My suggestion is to buy index funds or ETFs as the MER is way lower and you aren’t getting a lot of the new flavor of the month that some manager somewhere invests in heavily that then tanks. BreX, Nortel, etc. Had them all and apparently heavily weighted too!
Won’t touch another mutual fund with a 10 foot pole.
March 4, 2009 at 9:57 am
Well explained Gail! ( as always! )
March 4, 2009 at 10:10 am
Great Post! There are lots of online calculators that show the benefits of compounding interest on your investments. It is amazing to see what one less meal out per month can turn into!
March 4, 2009 at 11:04 am
Don’t let the formula scare you, especially you math-haters…it’s easy for yourself to calculate compounding interest and the future value of money and such:
X * (1 + i) exponent n
where
X = the amount of money you want invested/saved (eg. $1,000)
* = multiply
i = interest rate (not in percentage though), so 10% = 0.10
exponent n = time period you’re looking at – as an example, think of it as 3 squared which is 9, right? 3*3. Well, instead of 2, make it anything you want – say 3 exponent 3 is 27 => 3*3*3
example:
how much would $1,000 be worth in 5 years if it’s earning 5%, paid out once a year? twice a year?
1,000 * (1 + 0.05)(‘exponent/power of’ 5) = $1,276.28 (when interest paid once a year)
1,000 * (1 + 0.025)(‘exponent/power of’ 10) = $1,280.08 (when interest is paid out at twice a year at 5%/year or 2.5% every 6 months)
exponent 10 is used because it’s 5 years but 2 payments a year so 5 * 2 = 10
It may look scary, but try looking to understand rather than getting paralyzed because all you see is math symbols. It’s really quite an easy formula – but definitely a calculator is needed as it would be a challenge to do mentally.
For Excel buffs, that formula falls under the FV function (Future Value function).
March 4, 2009 at 11:09 am
Gail:
I agree about the magic of compounding and I don’t want put people off of compounding interest, but I have to ask:
“Susie has a twin sister, Sami…” If you include the time value of money, how far apart are they? The time at which Susie and Sami put in their money means that Susie did put in more money. What % is typical to use for the time value of money and do you just remove it from your investment interest or is the math more complex?
I know that you want your investment return to beat the time value of money otherwise your are loosing money. But the math must be accurate. I saw the same thing in Bach’s book.
March 4, 2009 at 11:15 am
Funny how you can know about compounding but still not save. I remember learning formulas to figure out compounding interest in grade 11 math, but I still save very little. BUT…I am making little changes each day. I plan on paying myself first (for savings and an RRSP) as soon as I start my full time position in a couple of weeks.
I just wish there was a magic wand that could convince my husband that we are not made of money and that we really do need to buckle down and make even bigger changes. Funny how working out a budget didn’t really do that. I find I give in easy right now and I can be just as bad when it comes to spending…
BUT little changes are better than no changes and they have been adding up. I am very proud to say that we just paid off one bill and I have started to tuck away money for big bills we know are coming in the near future. We had been relying on my husband’s bonuses for those previously, but I would rather have those for a trip to visit family (quite expensive – 3 seats @ $1300 each) to keep my sanity.
Thank you Gail for the Blog. I read it every morning while the kids play and I sip a cup of tea (the cheapest brand now). I have learned a lot from you and your show. I was hoping to convince my husband to do the show, but that would ruin that illusion that we have more than we do.
The comments have been fantastic too.
Thanks for listening to my blurb.
March 4, 2009 at 12:24 pm
@ Jackie,
We have relied on bonuses years past to catch up as well. A dangerous plan as I’m guessing many companies will see this year as the start of lower or no bonuses… With any luck this won’t be you, but you never know.
If I had the magic wand I’d just wave away the debt – forget about using it for convincing
March 4, 2009 at 12:24 pm
Rumour also has it that when asked what the invention in human history was, Albert Einstein replied “compound interest.”
March 4, 2009 at 12:32 pm
[This year’s RRSP contribution when right into the index.]
Mine too… the lowest mer no load indexes I could find… let’s hope that’s a good strategy.
March 4, 2009 at 1:07 pm
@ Ioana — the lowest index fund I’ve found is TD e-funds series. Which one did you find?
March 4, 2009 at 1:23 pm
Oh the power of compounding interest is amazing, but it only seems to work in the favour of my mortgage lender instead of in my investment portfolio!
I have been saving consistantly for over 15 years (since my my early-mid twenties) and the RRSPs are presently worth LESS than I have put in after all these years. UGH. I have not taken a penny out for anything, but there they slump. And I made sure they were “moderate/conservative” investments too!!!! Oh the good news is that I have lots of time left and I am still contributing, and each dollar buys more shares than it did before, but it still is grossly depressing to see that compound interest calculation take a big DUMP.
Sigh…. I suppose I can say “at least I have started with SOMETHING”, some days it feels pointless.
March 4, 2009 at 2:40 pm
@Jackie, if you sit down with raw after tax numbers from income statements and bills going out, you’d be amazed at how the proverbial bull is grabbed by the horns. I did this last week with my husband when deciding whether to take a full-time job with benefits rather than consulting. When we did the math on what I put out, he was appalled. In any event, now he doesn’t even want me to buy a coffee because we need to ‘be prepared’ for future!
March 4, 2009 at 3:18 pm
When I was helping my brother do his budget, I showed him how much his money would be worth if he start now rather than starting 10 years later. He is amazed and agreed that now is the best time to put it away.
March 4, 2009 at 3:30 pm
geoff: here’s what I did. I couldn’t get the e-series because I have a scotia account from my work (they double my rrsp so I get it with them). I got the i-series instead, more expensive, sigh. Actually a lot of the funds I picked were because of the restrictions with the Scotia account.
I didn’t do as much research as I wished so I’m not exactly sure if it was the best, and I’m a newbie at this, but I tried to diversify across sectors and geographically:
1. Scotia Global Climate Change – 8% (the conscience fund)
2. CIBC Energy – 8% (there was no index for energy)
3. CIBC Balanced Index – 8%
4. TD International Index – 8%
5. TD Precious Metals – 8% (no idex for this one either)
6. CIBC U.S. Broad Market Index – 11%
7. TD Japanese Index – 8%
8. CIBC Nasdaq Index – 11%
9. CIBC Canadian Bond Index – 8%
10. TD Canadian Bond Index – 5%
11. CIBC Emerging Markets Index – 8%
12. CIBC Canadian Index – 8%
That’s it…. would be interesting to know what you think.
cheers,
ioana
March 4, 2009 at 4:30 pm
Ioana, I’m not a financial planner but I think you’ve done a good job of covering all your bases — too good actually. You’d have to get the prospectuses (prospectisi?) out, but I wonder with 12 mutual funds if you’re not investing in many of the same companies while paying out a MER and other fees. Perhaps consider consolidating some of the same funds (ie you’re in CIBC CAnadian Bond Index and TD CDN Bond index, I wonder if that’s mostly the same investments) and then seeing how you’re diversified. I’m 20% in Cdn Bonds Index, 30% Cdn Equity, 30% US Equity and 20% Int’l Equity and that’s it (all TD e funds). At least that’s the target distribution, it’s probably +/- 5% in all categories right now. This also makes the math a lot easier to see how you’re doing versus target and prevent overlap. Keep in mind I’m not a professional and am uh.. evil so please use your own judgement at all times (ok not evil but making a point)
March 4, 2009 at 4:42 pm
@geoff – Thank you for your answer!
From what I understand, there are no other fees except the MER (they’re no load) – and since the MER is a %, it shouldn’t, mathematically, make any difference wether I break the portfolio up, right? or am I missing something?
(I am a geek)
PS: you’re not a financial planner? you’re more trustworthy then!
March 4, 2009 at 6:20 pm
I’m with Geoff. Seems like a lot of funds, so I would suggest the KISS approach.
2 Canada bond funds? A fund in Japan and international? Canada is typically weighted heavily in resource equities, so probably considerable overlap with the energy fund and precious metals too. Since you clearly have established diversification, for simplicity you’d probably get the same result by having just the Canada index for your energy/mineral sector. If you going for a more riskier outlook, which you’re not, then yes, an energy fund is different from a Canada index.
Just food for thought. But I too am not a financial planner. oh, plus keeping 3-5 funds makes it easier for a PAP setup.
March 4, 2009 at 9:26 pm
wow. am I LEARNING a lot.
i started ‘paying’ myself first very late in the game….but better than not correct?
i’m loving the support and good advice given freely here.
got burned by a financial advisor i didn’t like (read that as didn’t trust).
now i listen to my ‘gut’ as well as reading everything i can get my hands on when investing my hard earned dollars.
i’m also thanking GOD for my many blessings.
March 5, 2009 at 1:35 am
I really am clueless when it comes to RRSPs and stuff, I rely on my hubby for advice on those. My husband is basically anti RRSP’s because he doesn’t like the lack of control amongst other issues.
My husband also thinks we have too many bank accounts. we have a joint account, a savings account for both of the boys and my buisness account.
I think its important for both of us to agree on our money issues .
March 5, 2009 at 8:53 am
Angela – you should gain at least a basic understanding of what you have and where (ie amounts, firms, account #’s) to have in case of death or divorce – life’s unpredictable. I would be at least a little concerned that your husband is anti RRSPs; that’s like saying he’s anti Money because he once got hustled out of $20. There’s a wide variety of options for RRSPs many that are very flexible and can all be managed online at home.
Ioana – while technically you are correct if they are all the exact same MER and have no other fees (it’s unlikely they have the exact same % mind you) it doesn’t matter, as Erran says it’s easier to setup automated payments with only 3 – 5. Also as mentioned earlier, it makes the math easier to see how diversified you really are.
It’s really brave of you to put your account info here. I wonder if Gail could do a post asking everyone to do that? (No personally identifiable info to be posted)
P.S. Diana – Not all financial advisors are bad just want you to know that. Some are good, some are evil, and some are incompetent but that’s true of any profession (ie remember some of our teachers in school?)
March 5, 2009 at 11:19 am
Oh I know where our money is and how much we have and what my husband puts away for cpp and how much his work matchs, im the one who takes care of our finances, im just clueless when it comes to rrsp stuff.
Our account is joint the others i have control over, my buisness account, and my boys accounts. We won’t ever get divorced that is not an option for us .
anywho, just sharing, the money we have is just in accounts or around the house, no investments besides the bank, that may be a bad thing according to some people but like i said before, both people have to agree on where you put your money.
March 5, 2009 at 11:23 am
ok so i just talked with my husband hes not anti rrsp hes anti resp
he says he doesn’t know enough about rrsp’s yet, there ya go! talking clears everything up
March 5, 2009 at 12:20 pm
@geoff – no I’m not brave, I just can’t see any harm in posting what my investments were for this year… can’t think of any!
The reason I diversified so is because right now I received a bonus, and lots of the funds on that list have a minimum amount. Well, in a regular month I won’t be able to put down that mininum amount if I wanted to purchase it. So if I put the minimum amount down now, then I will be able to set up PACs with these funds for their “additional” amounts which are as low as 25$.. so I’m just trying to keep my options open…
does this make sense?
March 5, 2009 at 1:16 pm
@ Ioana – it is brave in my opinion to put your own life out there (no harm, just brave). Your reasons make sense but you should be able to fold some of them into the others now that they’re opened, but find out about any fees / limits to be aware of.
@ Angela — have to ask — – why is your husband anti-RESP? Gail’s posted on the virtues of an RESP and I don’t understand why anyone would be against them. Unless they’re against saving for a child’s education in general, an RESP is without a doubt the best way to save for the majority of people. There would be exceptions almost by definition but I can’t think of any, maybe your husband has some rationale? (Keep in mind the differences between an individual RESP, a family RESP, and a group plan RESP may come into play here).
March 6, 2009 at 12:18 am
The only thing i know about my husband being anti RESP is the lack of control. I did talk to him today briefly about at least trying to get the free $500 from the government for our kids he wants to look more into it. He has talked to various groups about them. I trust my husbands judgement so im not pushing too hard about it.
March 6, 2009 at 9:46 am
Angela — I’m not sure what you mean by groups, but please tell your husband to view any group resp plan (Heritage, CST etc) with EXTREME CAUTION. Most have severe penalties if you suspend payments, and ALL will take your initial payments as fees and not earn a return on them. You don’t need to go with any group plan to get the $500, a plain old individual account with a bank will get that for you too.
March 6, 2009 at 11:12 am
@angela, I second what geoff said, to the letter.
It’s worth looking into it because of the 500$ a year which otherwise you’re missing. The most important thing that my parents gave me was to pay for my education.
The only thing you need to do, is open an account with the bank as an RESP account (you’ll need the kids’ social insurance numbers) and then put money in it.
March 6, 2009 at 1:46 pm
yeh it was heritage that my husband talked with, im still working on my husband on it, we do have both our boys SIN cards so the only thing stopping us is both of us agreeing.
March 6, 2009 at 1:53 pm
Angela:
You can open up an RESP at most banks. You can keep the money in a GIC if you are worried. The biggest gamble is whether the kids will want post-secondary education.
March 6, 2009 at 2:58 pm
I think that may be another worry of my husbands. He asked me if we had to put it in one of the kids names or both and just see who needs it. Not knowing where we will be living and what jobs our kids get you just don’t know. If we are still in alberta there is a chance that the kids may just get a good paying job here that you only need highschool for. You just don’t know.
March 6, 2009 at 3:10 pm
And it’s not much of a gamble; worst case is that you’ll be able to put all your contributions into your rrsp and/or pay some extra taxes on them, not like it’ll go to waste (government match goes back to government though). but I mean really, what are the odds that a child won’t go to ANY post-secondary in 15 years? It’s hard enough today to get a job with only high school, let alone two decades from now. And especially if they know they have at least some money to pay for it (I paid for my education out of my own pocket/borrwing from osap and would rather spare my son that drag if at all possible, though I won’t be writing a blank cheque either).
March 6, 2009 at 3:13 pm
@Angela, I’m still trying to give my son a sibling so I put my RESP under “Family RESP”. So it will be available for all of the kids.
I found this by chance about alberta:
“What should I do when a child chooses not to continue education after high school?
• Wait for a period of time, he or she may decide to continue studying later.
• Use the money for a brother or sister who will continue studies at the post secondary level.
• Transfer up to $50 000 into a Registered Retirement Savings Plan (RRSP).
• You can withdraw your personal contributions tax-free, the interest accrued will be taxed.
• Any Canada Education Savings Grant paid into the plan that cannot be transferred to an
alternate beneficiary, this must be returned to the government. However, interest or
investment growth earned on grant money does not have to be paid to the government.”
http://www.su.ualberta.ca/services_and_businesses/services/sfaic/forms_and_reports/RESP%20Tip%20Sheet%202008-2009
March 6, 2009 at 3:33 pm
Um which makes me wonder… say if I put in the RESP 50000 (the maximum)…. and then I move that amount into the RRSP (paying tax on the 2.5% interest that this will make me – I’m an optimist) and use the 12500 I receive in grant for my child’s education… is this kosher?? Can’t be.
March 6, 2009 at 3:58 pm
Ioana:
Hummmm…
Angela:
If towards the end of your child’s high school you find out that a post-secondary education is not the path…
Stop contributing to the plan (RESP), limit your contributions to your RRSP so that you have the contrubtion room available for the transfer.
YOU NEED RRSP ROOM to do the transfer without penalty.
May 20, 2009 at 3:25 pm
Great writing! will definitely come back soon..