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Previous generations have had some help in achieving financial security that young people can't count on today: generous employer pensions, steady housing price increases, and a ...
Previous generations have had some help in achieving financial security that young people can't count on today: generous employer pensions, steady housing price increases, and a well-funded Social Security program, to name a few. In short, the old "muddle through" approach won't cut it anymore - not even close. A steady income is still a must, but parlaying this into long-term financial security is now an entirely different proposition than ever before. The institutions of the past can no longer be relied upon to handle the process; each person now needs to manage the long-term financial planning and decision making on their own.
Fortunately, though, anyone just starting out can still achieve a very strong financial future from almost any income level - but only by doing the right things to make it happen. Those things aren't particularly hard to understand or to do, but it is important to do them right, to do them consistently, and to do them in the right order. Most importantly, if you get an early start, the risks are minimal and the payoff is substantial. But each year that passes, the risks go up and the payoff goes down. If you have just started out in your financial life, or if you are just about to, and you want a complete and practical education in the fundamentals of personal finance for a secure future, then this book is for you. Chris Smith guides readers through the basics of saving, investing, and financial planning in language that is clear, accessible, and lively, making difficult concepts understandable to the novice, and enjoyable to those who already have some understanding. He shows readers how to apply this knowledge, and to avoid the most common pitfalls, to insure the best possible outcome for long-term financial security.
In the world of personal finance, there is a power so great, so completely dominant, and so incomparably mighty, that any serious book about personal finance simply must start with it. But I'll warn you ahead of time that when I tell you what it is, you probably won't be too impressed. You see, as truly amazing powers go, this one doesn't make that great of a first impression. It's a little bit like meeting Clark Kent for the first time, with his thick glasses and baggy suit in his office at The Daily Planet. "This is the Man of Steel?"
Part of the reason for this is that the power we're talking about is ... well, sneaky. When it first makes its appearance, its effect is so small as to barely be noticed at all. Only when given enough time to pick up steam does its real power begin to become apparent. Eventually, it snowballs into a force that is completely unstoppable. But when I tell you what it is, you'll say "What, that?"
And before we go any further, it is vital that you understand something else about this power: it can either work for you or against you. It isn't neutral. It picks one side, friend or foe, and gets right to work.
I am starting with this subject for two reasons: first, because it is the single most powerful idea in the whole field of personal financial management. The majority of people who are in great shape financially are in that position because they understood this power and have had the patience and discipline required to use it to their advantage. On the other side of the coin, it is even more common for people to be completely and utterly wiped out because they didn't understand that this power was working against them; or, more likely, they knew it was working against them but deeply underestimated by how much. The second reason that I'm starting with this power is that we will come back to it again and again when discussing other topics, so it is good to have a solid understanding of it right from the start.
Okay, so what is it? What is this overwhelmingly powerful force? Are you ready?
Yes, compounding. If you were first introduced to it in a math class, it might have been called powers or exponents. Later on in math, or in a science class like biology, you might have covered the idea of exponential growth. Well, compounding is really the same thing, but applied to your personal finances, where it is usually referred to as compound interest. You can either earn compound interest or be charged compound interest. You earn compound interest when you save and invest; you are charged compound interest when you borrow.
If you think you already pretty much know about compounding, and that this chapter is just a repeat of something you've already learned elsewhere, you're not alone. Most people believe they already understand this, and maybe you're one of those who really do. But just in case, I'd like to ask you to read through the next part carefully, anyway.
You see, I am already assuming that you know the basics of how the math works, and that you already know, at some level, that the effect is really big. The main point I want you to get from this explanation is just how big the effect is. In fact, I want you to learn this with such a jolt that you come away thinking, "Wow! If I don't learn anything else from this book, I want to figure out how to get this power working for me and not against me." So I ask you to read on, remembering what you know about the math, but with a completely open mind about how powerful the effect is.
So here we go—time for a simple multiple-choice question. No calculator, no pen or pencil, just from what you see below: What would you rather have, A or B?
A. One million dollars, valid U.S. currency, cold hard cash, tax free, right now.
B. Picture an ordinary checkerboard, 8 rows of 8 squares each. That makes 64 squares in total. Let's say I start with the first square, in the lower left-hand corner, closest to you. I will put a penny in that square, then two pennies in the next one, four pennies in the one after that. By the time we get to the end of the first row, there are 1 + 2 + 4 + 8 + 16 + 32 + 64 + 128 = 255 pennies, or $2.55. Now I will go on, square by square, doubling the number of pennies each time, until I have the whole board completed. When I am finished, you get all the pennies on the checkerboard. Got it?
All right, I know what you're thinking—I just spent several paragraphs telling you how amazingly powerful compounding is and now throw this obvious trick question at you? Good test taker that you are, you spent 2 seconds thinking about it, then said, "Easy! B's gotta be the right answer!" Well, you're right—of course, it's B! But now comes the real point: again, without calculating anything directly, take a stab at just how much better B is than A. Is it twice as much? More like 100 times? Remember, I've already told you that I am trying to completely blow you away with how powerful compounding is, so go ahead and guess really high—just remember your guess.
Okay, so what's the answer? Let's start by considering how many pennies are only on the 64th and final square. The answer? Well, there are this many pennies: about 9,200,000,000,000,000,000, which is otherwise known as 9.2 quintillion. Oh, you want that in dollars? About $92 quadrillion. Also known as $92 million, a billion times.
But that is only the amount on the 64th and final square. Don't forget that there is half that amount, $46 quadrillion, on the 63rd square, and $23 quadrillion on the 62nd square, and so on. By the time you add up all the squares on the whole checkerboard, you've got something like $184 quadrillion.
That amount is a little hard to think about, isn't it? What does $184 quadrillion even mean? Here's one way to think of it: picture yourself living in the year 3800 B.C. The Roman Empire, the Greeks, the Egyptians—these civilizations did not yet even exist. Ancient people like King Tut, Moses, and Alexander the Great were thousands of years in the future. Emperor Qin Shi Huang wouldn't unify China and begin construction of the Great Wall for another 3,000 years. Even the prehistoric structure of Stonehenge was not yet imagined.
So what was going on then? One notable culture at the time was centered in Mesopotamia, and most scholars agree that there was a revolutionary new technology just breaking through there called (get ready ...) "the wheel"! (First used in pottery making, then mill grinding. Using wheels for transportation was still a long way off.) So imagine that you're that bright Mesopotamian who came up with the first actual wheel. In your glee, you decide to celebrate by going out and spending a little money. If you walked out of your wheel-hut that afternoon and immediately began spending 1 million dollars per second, around the clock, without stopping to eat or sleep, day after day, year after year, you'd be just getting close to $184 quadrillion—today!
Remember our A vs. B multiple-choice question? Now you know—B isn't twice as big as A, or 100 times. It is 184 billion times bigger than A. How does that compare to your guess?
I hope I have your attention and that you don't think that I was exaggerating when I called the power of compounding truly amazing. Compounding has been called the eighth wonder of the world, and now you have an understanding of why.
MORE ABOUT COMPOUNDING
Some of you more math-friendly types probably want to see how the staggering checkerboard result was reached. Fair enough; I'll take you through it in the next paragraph. But if you're not that interested in the math and prefer just to take my word for it, that's okay too. It is much more important to appreciate fully what compounding can do than it is to understand the mathematical mechanics. So, mathletes, read on; everybody else, just feel free to skip the next paragraph.
Optional checkerboard math explanation: The number of pennies in any square is 2(N-1), where N is whatever square you're on. Since there are 64 squares on our checkerboard, the number of pennies on the last square is 263, which just about any calculator or spreadsheet program can tell you is about 9.2 quintillion, or $92 quadrillion. And since each square is double the preceding one, the total number of pennies on the entire checkerboard is one penny less than double what is on the last square. (You can either add up all 64 squares on a spreadsheet to get this, or use some fancy summation rules math to deduce that the total equals 2 X N64—N0, or $184 quadrillion minus a penny.)
Let me assure you that you don't need any high-level math skills beyond basic arithmetic to understand fully what compounding is all about. Here's a much simpler explanation of the math involved: compounding just means taking an amount and then continually increasing it, over and over again, by the same fixed percentage. Since each increase is constantly proportional to each beginning amount, the increase amounts get bigger and bigger with each cycle.
There is a very important aspect to the way compounding works that I want to make sure you notice. Even though the math guarantees that the rate of increase will be smooth, our perception of it doesn't tend to work that way. Instead, unless we're paying exceptionally close attention to each and every increase, we tend to notice it in distinct phases. In the first phase, the increases are tiny. If we notice them at all, it is simply to conclude that they're too small to ever amount to much, so we dismiss them as barely worthy of attention. After enough time, though, the amounts get big enough to mildly surprise us. In this phase, the compounding has really begun to "pick up steam," and we begin to conclude that it really might add up to something significant after all. After even more time, we enter the third phase: this time, we aren't just surprised by the size of the increases—we are astonished! An easy way to think of these three perceptual phases is this: the "snoring" phase, the "eyebrow-raising" phase, and the "jaw-dropping" phase.
In our checkerboard example, by the time we get to the end of the first row, we have only $2.55; the very idea that this little scheme could ever compete with $1 million in cash seems laughable. Watching the tiny increases is enough to put anyone straight to sleep. At the end of the second row the total amount has grown to $655.35. This is still far short of our $1 million alternative, but it is enough to make us raise our eyebrows, as we begin to realize that this checkerboard scheme might have a chance to really add up to something. The pennies reach the $1 million mark during the fourth row—less than halfway through—and our jaws drop with the realization that we are witnessing something astounding. With the completion of each successive row, our jaws drop further and further. We are now well into the third phase.
This is why it is really important to learn about compounding when you are young. The earlier you begin letting the power of compounding work for you, the more time you have to let compounding build up momentum and get into its most powerful stages. Someone who starts at age 20 and utilizes positive compounding until they are 60 has 40 years of compounding working to their benefit. Someone who waits until they are 40 to put compounding into place has only 20 periods of compounding to work with. Before you read this chapter, you might have thought that 40 periods would be twice as good 20. But now that you know about the checkerboard, you know the truth—40 years of compounding is immensely better than twice as good as 20 years.
By now, it is probably becoming quite apparent to you why compounding is such a huge concept in personal finance—because the effect is so unbelievably powerful. How powerful it is depends, as we've seen, on how long the compounding goes on. But it also depends on how fast we compound. In our example, we doubled the number of pennies with each successive square. We would have gotten a different answer if we had tripled or used some other compounding factor. In finance, the fixed percentage at which amounts are compounded is called the interest rate. That's why financially smart people pay very careful attention to what might seem like very small changes or differences in interest rates.
Of course, the checkerboard example isn't too realistic; doubling your money with every time period is equivalent to an interest rate of 100%. (In fact, if you find a "checkerboard" investment opportunity that promises to double your money every year, contact me immediately. Better still, keep your money in your pocket and contact the authorities, because it is almost certainly a scam.) We chose the checkerboard for its dramatic value, not for its realism. But that's okay, because you don't really need $184 quadrillion to be considered a financial success. I'll bet you'd settle for a measly trillion or two.
In real life, safe and legitimate investment opportunities that can consistently deliver a 10% interest rate per year are rare but not unheard of. On the other hand, it is quite easy to find real-life examples of compounding working against you at interest rates higher than 10%; almost any credit card will do it. That brings us to another important truth about compounding: as amazingly powerful as this force is when you save and invest, it will usually work even harder against you when you borrow. Why is this? It doesn't seem quite fair, does it? We could enter into a long discussion about why this is, but that is beyond the scope of what we need to cover here. For now, just realize that nearly always, the interest rates that you'll pay for borrowing are usually higher than those that you'll earn from saving and investing—sometimes by a little and sometimes by a lot.
CASE STUDY: COMPOUND UNIVERSITY REUNION
Xena, Yolanda, and Zelda were friends and college classmates at Compound University, and they attended their graduation ceremony together. The commencement speaker was very interesting. He spoke about the importance of saving and investing, and he stressed that making it a lifelong habit could really pay off in the long run. Further, he explained how one could invest in such a way as to consistently earn an average return of 6% per year over a long period of time, without taking any unreasonable risks.
Note: Compound University is located in a mythical land without taxes or inflation. That doesn't mean that those aren't important; they are, and we'll talk about them both later on. It just means they have nothing to do with the point of this particular case study.
After the ceremony, the trio sat down for one last cup of coffee together at their favorite hangout. Xena was the most impressed. "Wow! That guy was absolutely right, and I'm following his advice. Here's what I'm going to do: I'm going to put away $1,000 a year, every year, no matter what, for the next 40 years. Some years will be easy, some will be harder, but I won't skip a year. I'm going to invest it just like he said and earn 6% a year on it. What do you say? Let's all do it!"
Yolanda was also pretty impressed, but she had a slightly different take. "I'm with you, Xena, but I want to be realistic. I think I could manage to save $1,000 a year for quite a while, especially when I'm young. After all, we've been starving students these past few years, so I'm already pretty used to living on a tight budget. But after a while, life will get more complicated. There will be houses, kids, cars ... kids with cars ... and then kids in college. I just don't think it will be realistic to be planning on saving any money during those 'high-expense' times in my life. But I'll meet you halfway: I'll save $1,000 a year for the next 20 years, invest it just like you will, but then I'll stop. I won't dip into the investment during the following 20 years; I will let it continue to earn interest. But I'm just not going to add any more to it after the 20th year."
"Yolanda, you've got it completely backward," said Zelda. "Think about it. We're just graduating now, and our pay over the next few years is going to be the lowest that it will ever be. I think that $1,000 a year is out of the question when we're just starting out. Plus, we barely own anything now. We each have to buy a first car, a first TV, a first set of furniture, probably a first house—all out of our low starting pay. But the odds are, our pay will keep going up throughout our careers, and after enough time, $1,000 will be pocket change. So I'm doing the opposite of your plan, Yolanda. I'm going to save $1,000 a year, just like you, and for 20 years, just like you, but I am going to start in year 21, just when you're stopping. I think that is much more realistic."
Excerpted from Securing Your Financial Future by Chris Smith Copyright © 2012 by Rowman & Littlefield Publishers, Inc.. Excerpted by permission of ROWMAN & LITTLEFIELD PUBLISHERS, INC.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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