The Miracle of Compound Returns

Previously, we learned about opportunity cost. But how can this concept help us save smartly? We'll dive into an example illustrating the miracle of compounding, and use opportunity cost to understand the importance of saving and investing early and often. Let's take these two investment scenarios.

In the first scenario, meet Myopic Mary. She starts saving in her 30s, and by age 45 has $20,000. She then invests this money in a retirement fund that earns a 7% annual rate of return and doesn't touch her investment until retirement. How large will Myopic Mary's $20,000 grow to be if it's growing at 7% for 20 years, until she turns 65? For simplicity, we'll use the Rule of 70, which allows you to quickly approximate how long it will take for an investment to double in value given a specified rate of return.

To see how many times Myopic Mary's $20,000 will double, simply divide 70 by the rate of return or growth. So 70 divided by a rate of return of 7 equals 10, which means her money doubles approximately once every 10 years. Since she's investing for 20 years, her money doubles twice. Myopic Mary's $20,000 doubles to roughly $40,000 by the time she's 55, and doubles yet again to $80,000 by the time she's 65 and ready to retire. So she started with $20,000, did not save a single cent more, reinvested her returns, and, after 20 years, ended up with about $80,000. Not too bad!

Now, onward to scenario two. Imagine Myopic Mary goes back in time 10 years, and becomes Meticulous Mary. Meticulous Mary starts saving in her 20s so that by age 35 she has $20,000. At this point, she invests her money in a retirement fund that earns a 7% annual rate of return and doesn't touch her investment until retirement. Our Rule of 70 calculations are exactly the same as scenario one. Given a 7% annual rate of return, Meticulous Mary's money will double every 10 years. The only difference from scenario one is that Meticulous Mary's money will double three times instead of two times. She now has 30 years until retirement, instead of 20. Meticulous Mary's $20,000 will double to $40,000 by the time she's 45, will double again to $80,000 by the time she's 55, and will double yet again, to $160,000, by the time she's 65.

So, let's recap. Both Marys, Meticulous and Myopic, invested the exact same amount, $20,000, at the exact same rate of return, 7%. The only difference between these two scenarios is time. Meticulous Mary started investing just 10 years earlier, and that led to $80,000 more dollars. How can that be? It's the miracle of compounding! Meticulous Mary started saving earlier, and that means that when her investment reached $80,000, she had one more 10-year period, one more doubling period still to go. And it's that last doubling that is the biggest doubling.

When people start to save, it often seems slow and pointless, because things don't change all that much. The rate of absolute change gets faster and faster. This is what people mean by exponential growth. And keep in mind, Meticulous Mary stopped saving at 35. Imagine if she had continued contributing to her retirement fund until she retired. That would be an extra 30 years of additional savings, and additional compound returns.

Now let's think about this through the lens of opportunity costs. Every dollar Meticulous Mary had and invested at 35 turned into $8 by the time she was 65. Contrast this with poor Myopic Mary. Every dollar she had and invested at 45 only turned into $4 at 65. Quite the difference! But the real takeaway from these two scenarios is not about Meticulous or Myopic Mary. The real takeaway is that you should be saving and investing early and often. And yes, I understand -- saving is hard to do. And where should you even save and invest?

Fear not. We'll cover some helpful saving tips and details about common retirement plans in future videos.