Principle #3 – The Principle of Compound Growth

Definition:

1. exponential growth

It is fairly safe to say that most everyone has at least heard of The Principle of Compound Growth. It is also fairly safe to say that most everyone also understands what it means. That said, I am just as certain that very few people truly understand the power, impact and implications compound growth truly has, especially as it relates to money.

The very best way to explain the importance of The Principle of Compound Growth is through a very simple illustration called “The Penny Story” which goes like this:

The Penny Story

The Penny Story begins with this question – If I took a penny and each day double its value, how much money would you have at the end of one month?

To be more clear, one penny doubling yields 2 pennies after the 1^st day, 4 pennies on the 2^nd day , 8 pennies on the 3^rd day, 16 pennies on the 4^th day, 32 pennies on the 5^th day and 64 pennies on the 6^th day. By the end of 1 week, in just 7 days, your penny has doubled again and again to where its value is now $1.28. With that information, I will ask you again, “If I took a penny and each day double its value, how much money would you have at the end of one month?”  Take a moment to think of a number yourself.

Is it $10?

Is it $1,000?

Is it $100,000?

Inevitably when I ask this question to one person or a large audience the answers are all over the board. Some are very low. Some are very high. Inevitably, no one EVER gives me the correct answer. In fact, no one has EVER even been close getting it right.

If I took a penny and doubled it every day for a month I would have $5,368,709.12!

Don’t believe me? It’s true! Just look at the table below.

Most people are pretty amazed with these numbers.  They wonder how just one little penny can become worth more than $5 million in just one month?  This is the impact of compound growth and it is very powerful.  While these numbers are pretty impressive, let’s analyze them further to see what lessons can be learned.

Lesson #1 – The Rate of Return is Relevant

Consider if I gave you a penny today.  Do you think you could have $5,368,709.12 in your bank account 30 days from today?  It’s not likely of course.  The question is “why?”

The answer should be obvious because earning a 100% return on your investment day after day is not easy. Frankly, I do not believe that anyone could achieve those results. Let’s slow things down a little. What if you started with a penny and instead of doubling your penny’s value every day, you doubled its value once a year instead? At the end of 30 years, guess how much money you would have?

Yes, you would have $5,368,709.12

Obviously, the rate of return is very impactful when compounding takes place.  However, when you are working with The Principle of Compound Growth time is far more important than the rate of return.

Lesson #2 – Time is Your Benefactor When You Have It and Your Nemesis When You Don’t

Think about it.  In 30 days we have over $5 million dollars.  On the 29^th day, however, we had only $2.6 (only!). On the 28^th day we had only $1.3 million, and on the 27^th day we had less than $1 million dollars. Take away just 3 days of compounding growth and our $5 million dollar fortune is worth less than a million dollars. Take away 6 days and you have less than $100,000. This clearly demonstrates that “Time is your benefactor when you have it and your nemesis when you don’t”.

The implications of this concept are profound. Simply stated, of all the financial strategies you could possibly consider when saving for your retirement, waiting to get started cannot be one of them. As it relates to your retirement, waiting to get started can provide you with only 3 possible outcomes:

1) To make up for lost time you can lower your standard of living when you retire because you will have less money to spend

2) To make up for lost time you can work longer and wait additional years before your retire

3) To make up for lost time you can increase the rate of return you earn from your investments

Which strategy and outcome would you choose? Truly, there are no other options. Of the 3 choices I believe that #3 is the worst choice of all. Unfortunately, however, this is the option most people take.  As a result they put their investments unnecessarily at risk to loss because it is IMPOSSIBLE to increase the rate of return without increasing the associated risk.  If you do suffer a loss, as stated in the Regeneration Principle, it takes a multiple in gain to make up for it. In other words, if your investments lose their value it just makes getting back to where you started that much more difficult. In addition you will have lost even more time.

On the other hand, if you start saving and investing now “time is your benefactor”. If you start saving and investing now you can earn lower rates of return and take less risk of loss and you will still achieve the results you want. By the way, if you start tomorrow you just wasted today. How valuable is just one day? Well, in our Penny Story it’s worth $2,684,354.56 on the 30^th day.

A More Realistic Example

Let’s agree that no one is going to be able to double their money every day or every year for that matter with any degree of safety.  Therefore, let’s look at the following example where a 35 year old couple wants to save $1,000,000 for their retirement at a reasonable rate of return like 7.2% per year. What would it take for them to accomplish their goal?  Hopefully by now you would say, “It all depends of if they start today, or if they wait,” and you would be 100% correct.

If they start today, they would need to save $794 a month

If they wait just 1 year, they would need to save $860 a month

If they wait 5 years, they would need to save $1,194 a month

If they wait 5 years to start saving and investing for their retirement they will need to increase their monthly contributions by more than a 50% just to make up for lost time. Or they would have to increase their Rate of Return on their investments to 24% a year, which is a 227% increase over the relatively safe and conservative 7.2%.

24% ROR!

227% Increase in ROR!

While a 24% ROR is not a 100%, it is getting up there. Can you earn 24%  from your investments? Of course you can.  However, a better question to ask is, “Can you risk the loss of your investment which could happen if you tried to increase your ROR to 24%?” Wouldn’t it be Better, Smarter and Safer Way to lower your risk by earning a 7.2% ROR and allowing yourself the time needed to achieve your goals?” Again, time is your benefactor when you have it and your nemesis when you don’t.

But wait, There’s More!

Lesson #3 – The Government’s Little Secret

Now let’s go back to the beginning of The Penny Story. After just 30 days of doubling our money we were able to obtain a substantial amount of growth. What if, however, you were taxed on those earnings? After all, Uncle Sam always wants to be your business partner you know. What if you were taxed 25% on the profits you made? How much money do you think you would have in 30 days with this reasonably small amount of taxes taken from your earnings?

Do you think you would have $5 million – 25% = $3,750,000?

Do you think it would be less?

Do you think it would be more?

Would you believe that you would have only $111,712.92?

It’s true! That’s “The Government’s Little Secret.” You see, the Government knows that when they take away even a small amount of your earnings over a long period of time that, in this instance, they robbed your of $5,256,996 of you potential wealth! How much more risk would you have to expose yourself to if you tried to earn a rate of return great enough to make up for this loss. How many more years would you need to work?  Too many people focus on chasing a 1-2% higher rate of return on their investments when they may be far better off learning how to reduce their taxes instead.

The Principle of Compound Growth is powerful indeed and there are many lessons to be learned. Understanding this principle is paramount and the three biggest takeaways from this are these:

1) Don’t wait to start saving and investing, it is a lousy strategy with no good outcomes

2) When you play The Penny Story with your investments, and you will because The Principle of Compound Growth cannot be avoided as it is one of the 12 Principles of Money, remember The Regeneration Principle and minimize or avoid losses altogether by lowering your rate of return.  Don’t put yourself in a position that forces you to make up for lost money and lost time.

3) When you play The Penny Story with your investments do what you can to keep Uncle Sam from becoming a greedy business partner. Uncle Sam provides you with ample legal means to accomplish this goal. You just need to employ them.

It’s a good life!

Randall A. Luebke RMA, RFC

Randy@LifetimeParadigm.com

www.LifetimeParadigm.com

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