Legend has it, Albert Einstein was once asked what the greatest invention of all time was. His answer? Compound interest. I am often asked when and how an individual can start investing. Those who follow these three simple rules will have the potential to improve their lives significantly.
Rule #1: For compound interest to be truly powerful, it must have the benefit of time. The more time, the better. Think of it like a snowball rolling down a hill. It starts out small and then gets bigger and bigger the longer it rolls.
For example, compare two investors who each put away $2,000 a year and earn 10% annually. The first investor starts at age 19 and puts away $2,000 per year for eight consecutive years and then holds it there. The second investor waits eight years and then invests $2,000 per year for the next 38 years. At the end of the 38 years, the first investor’s account will have grown to $941,054. The second investor’s account will be only $800,896. Because of the power of compound interest, the first investor avoids 38 years of payments and invests $60,000 less, but ends up with $140,158 more.
Small increases in rates of return make enormous differences over time. Everyone knows that a higher rate of return is better than a lower one. What most people don’t realize is that the benefit is exponential. A 15 percent rate of return is not merely three times more than a 5 percent rate of return. It can actually be anywhere from seven to seventy times more, depending on how long you invest. Start investing now.
Rule #2: You have to save money—and saving requires discipline. There are always plenty of reasons not to save. In your youth, you don’t believe you will ever reach retirement. Between the ages of 20 and 60, with kids, a house, cars, college, taxes, etc., there is never an ideal time to start saving.
Saving requires discipline. You must “pay yourself first” by putting aside at least 10 percent of your income. After paying yourself first, then pay the rest of your bills. The sooner you implement this habit, the sooner you will see your savings begin to grow. Otherwise, it will become one of those great ideas that never turn into reality. The key is to start now… because there will never be a good time to start. The sooner you start, the greater the effect of compound interest.
In order to invest, you need to have extra or excess money to save. Most people claim they don’t have extra money. The fact is that they don’t have extra money because they spend everything they have. Which brings us to the next rule.
Rule #3: Spend less than you earn. It seems like obvious advice, but it is often ignored. According to an article in Smart Money, Americans collectively spend more than they earn. This bad habit afflicts people at all income levels—those with less may feel as if the extra expenses are a necessary evil, while those with more may assume their high income protects them from any future financial trouble. This mentality must be changed in order to build wealth.
I’ve known individuals who earn $40,000 a year but have the discipline to save $5,000 for the future. Although it may seem like a small annual amount, that money, over time, adds up to future wealth and security. In contrast, I have met others who earn $200,000 a year and spend $220,000. This lack of discipline is a quick way to become broke, even if you have very good income.
Often, people assume that if you drive an expensive car or live in a luxurious neighborhood, you must be doing well financially. From my experience, this assumption is only accurate about half the time. The rest of the time people are living beyond their means. They have no savings and their net worth is actually negative. This group spends money faster than they earn it. They appear to be successful, but eventually crash financially and are forced into reality.
On the extreme side, I know people who earn over $4,000,000 a year who still regularly spend more. Over the years, by spending more than they earn, they have destroyed their net worth. This makes the point that a successful savings plan isn’t the result of earning more money. The critical element is having the discipline to spend less than you earn, regardless of how much you make.
Understanding these three simple rules is one thing. Having the discipline to implement them is another. Those who start investing now, save money, and spend less than they earn will be significantly rewarded.
Disclosure: Paragon Wealth Management is a provider of managed portfolios for individuals and institutions. Although the information included in this report has been obtained from sources Paragon believes to be reliable, we do not guarantee its accuracy. All opinions and estimates included in this report constitute the judgment as of the dates indicated and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security. Do not rely upon this information to predict future investment performance or market conditions. This information is not a substitute for consultation with a competent financial, legal, or tax advisor and should only be used in conjunction with his/her advice. Past performance is not a guarantee of future results.
Dave Young founded Paragon Wealth Management in Provo, Utah 29 years ago. His investment methods have attracted national and local attention. He has been interviewed by BusinessWeek, CNBC, the Wall Street Journal, the Deseret Morning News and other national and local media