“The greatest power in the universe is compounding interest” — attributed to Albert Einstein.
AVON LAKE, Ohio — Whether or not Einstein actually made such a statement, the truth of it is undeniable. After my Dec. 13 Plain Dealer commentary, “It’s never too early (or too late) to invest for your future — a brief guide for young investors,” It’s never too early (or too late) to invest for your future. A brief guide for young investors,” I received inquiries asking questions that I didn’t have the space in that first piece to answer, so I am doing it now.
Before doing that, however, let’s add a tweak to the Einstein quote: Which would you rather have, $1 million or a penny doubled every day for a month (that is, one cent becomes two cents on day two followed by four cents on day three and so on for thirty days). If you picked $1 million, you would have shortchanged yourself by $4 million. Go ahead and do the math yourself if you don’t believe me.
This is one of the classic examples of the miracle of compounding interest. None of us can hope to live long enough to have 30 doubling periods, but the Rule of 72 gives us a more practical guide. The Rule of 72 says that if you divide 72 by your rate of return, you get an approximate doubling time. For example, if we anticipate an 8% rate of return for 10 years, we will divide 72 by eight, yielding an approximate doubling period of nine years. Thus, over a 40-to-45-year retirement horizon, a 4½ to 5 doubling factor is not a stretch.
In my earlier commentary, I provided investing guidance as to where younger people could reasonably anticipate that number of doubling periods. I didn’t have the space then to wax eloquent on compounding interest or the next thing I mention below as a critical component to a young investor’s strategy.
I did talk about the absolute need for the investor to contribute enough to his or her Section 401(k) plan so as to maximize any employer match for the employee’s contribution. The example I gave was that, if an employer matches dollar-for-dollar the first 3% of employee contributions and the employee does indeed contribute through a salary-reduction agreement 3% of compensation, the employee has immediately doubled his or her contribution in a tax-deferred retirement account.
Reiterating that example is a good lead-in for emphasizing what is referred to as “dollar cost averaging.” As I have tried to advise my own kids, grandkids, and students, trying to time the market — that is, making investments in anticipation of upcoming highs and lows in the market — is a fool’s game.
Dollar cost averaging is the antithesis of trying to time the market. Under this approach, the investor invests the same amount of dollars every designated period, ideally every month or two weeks, as in the Section 401(k) example, in good times and bad, ignoring the inevitable market peaks and valleys.
Mark Altieri is a Professor Emeritus of accounting at Kent State University.
Investing these dollars in well-diversified investments such as the ones I referenced in the earlier commentary yields a formidable result over decades of time. Despite the many claims to the contrary that you might see on television, America has the greatest companies in the world. It is also not debatable that over decades of time, stocks outperform other investments like bonds and even gold and silver.
I hope this helps, younger readers. Good luck!
Mark Altieri received the Certified Financial Planner certification from the CFP Board of Standards and the Personal Financial Specialist designation from the American Institute of CPAs. He is Professor Emeritus of Accounting at Kent State University, and special tax counsel to the law firm of Wickens, Herzer and Panza in Avon, Ohio.
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