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Wednesday, March 29, 2017

How Compounding Really Works

Posted by Tim Stobbs on June 30, 2016

It is interesting to me that while people sort of understand how compounding works with their investments.  They have been told they should start early and by reinvesting it will grow all by itself. Yet they really don’t get it on some level.  The reality is your first $100,000 in investments will feel like a climbing the biggest mountain in existence and then after that it gets significantly easier to build up your investments.  But rather than discuss this in a broad point of view, I thought it might be useful to go over my investment net worth and point out the time it took to grow between each $100,000 mark.

In the beginning, we have nothing.  Actually with student debt we have less than nothing.  After leaving university and getting married at age 22, my wife and I had debts around the $60,000 mark.  Yet we managed to get some jobs and start paying down our debt and also when I had the option of getting some free money at work via a RRSP matching program I took it.

Now guess how long it took us to save a house down payment, pay off our student loans and save our first $100,000 in investments?  Five years? Nope. Eight years? Nope, keep going.  In fact, I was 32 years old when we managed to hit that threshold.  It took us 10 years  (or 120 months) to save that much money and the thing was we were trying a big harder than the average person.  Now if that sounds like a prison sentence because in some ways it was.  THAT is the difficulty with saving your first $100,000. So when people talk about starting early, this is exactly what they mean.

Depressed yet?  Good, because now we get into the good news.  It gets easier after that first hurdle.  I mean a LOT easier and it just keeps getting easier from there.  Case in point it only took 3 years (or 36 months) to reach $200,000.  Or putting that in context it took 70% less time than the first $100,000.

Then it just kept getting easier.  Hitting $300,000 only took 16 months, so that would be 86% less time than the first $100,000.  Basically that one happened so fast it was like getting investing whiplash as compared to the glacial slow pace of the first $100,000.

Ironically getting to $400,000 took even longer at 19 months, but that did include the collapse of oil prices so somewhat understandable that it would take a bit longer, but still roughly about a 1.5 years.

Finally, while I’m not there yet, my current projection would be to hit $500,000 around Feb of 2017, so that would be only 13 months long, which if correct would be about 90% less time than the first $100,000.  And of course if you keep going it just keeps getting more and more easier to add wealth (no wonder the idea of working just one more year is so popular for people that are almost retired).

The point of all of this is when people give you some well meaning advice to start earlier even with a little bit of savings: PLEASE FOLLOW IT! You will be further ahead in the end and guess what, you don’t even need to consider retiring early when you start out.  Oddly enough you will have lots of time to make the decision in the future and guess what, the worse thing that happens is you have a large amount of savings to make other choices in life.  Some flexibility isn’t a bad thing, after all you never know where you are going to end up so some extra cash to consider starting a business, buying a cottage or taking a unpaid leave from work.  Do what ever you want, just please consider saving something to start climbing that mountain now.  Good luck on your climb.

Comments

2 Responses to “How Compounding Really Works”
  1. RICARDO says:

    Morning Tim;
    Yes, componding does work quite well.
    I only atarted to track my returns in 2010 @ $16.7K for the year Six years later, end of 2015, I am at $59.4K per year. This year I will be probably be a bit lower than that because of the oil bust and ensueing div cuts and a few div eliminations. Never the less, that is still an extra 100K every two years that come in on their own without me putting in any time or effort.
    Divs are re-invested and I also max out the RRSP and TFSA every year so that helps increase the divs as well.

    RICARDO

  2. deegee says:

    Tim, I hit the $100k mark in investments just a month shy of turning 32, almost like you. Of course, in those early years I was saving up to buy my first car (and its replacement), buying my apartment, and paying off my student loans. The next $100kS took about 2 years each, hitting $500k just after I turned 40. In those 8 years, I paid off my mortgage, enjoyed the booming stock markets of the late 1990s and in 2003. But I also saw the value of my company stock zoom upward starting in 1997 when I turned 34.

    The company stock was the big reason I saw $100k increases about once per year, although simple compounding as you described in your piece also played a big role. Even as my wage income dropped, eventually to zero when I retired in 2008, I still saw growth in my portfolio in the last 8 years although the 2008-09 downturn caused me to take nearly 4 years to get from $900k to $1M.

    But your main point is surely true – compounding is great!

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