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“The most powerful force in the universe is compound interest” –Albert Einstein

As I placed the last chart in the discharge rack, a nurse unexpectedly asked me “What car are you driving home?”

“What car do you think I drive?” I responded hurriedly.

“I bet he drives a Bimmer,” shouted a tech.

“I parked next to a BMW, but I drive an 11-year-old Honda with over 200,000 miles on it,” I said.

“Yeah right. Then what do you do with all that money?”

“After buying my groceries at Sam’s Club, I save it,” I exclaimed as I waved my still remoteless keys.

alt Over the past 10 years of practicing emergency medicine, I’ve realized one of the most powerful but underrated techniques to achieve financial independence: making the most of compound interest. Compound interest refers to the interest which accrues on interest. For example if you have $1,000 invested at an annual interest rate of 10%, then after one year you would have $1,100 ($1000 original investment and $100 of interest). After the second year you would have $1,210 ($1000 original investment, $200 of interest on the original investment, and $10 of interest on the first year’s interest). Combining saving with compound interest leads to my three “S’s of saving: save early, save often and save more.

How effective are these principles of saving? Let’s consider three EPs in different stages of their career: a 30 year old (newbie), a 40 year old (mid career), and a 50 year old (late career). Let’s assume that each one wants to retire at age 65 with a $2 million investment portfolio and each has a gross annual income of $200,000. Let’s also assume a 10% annual investment return, which is consistent with historical standards. For this discussion, we will ignore inflation and taxes.

Save Early!
For the 30 year old to reach $2 million at age 65, he would need to invest about $7,380 per year, which is less than 4% of his gross income. The 40-year-old EP would need to save $20,340 per year or about 10% of gross income—still an obtainable goal. The 50 year old would need to save nearly $63,000 per year or a whopping 31% of his income. If the 50 year old has two college aged children and a home mortgage, he may need to delay retirement, cut expenses, underfund college savings, or work more shifts (assuming that he stays healthy enough to do so). Looking at it another way, the 50 year old needs to save over 8 times more money per year than the 30 year old.

Save Often!
The above analysis assumes once per year investments. Let’s see what happens when each EP invests a weekly sum instead of a yearly sum. The 30 year old would need to invest about $120 per week or $6250 per year to reach $2 million at age 65. The 40 year old needs to save about $345 per week or $18,000 per year, while the 50 year old needs to save $1100 per week or almost $58,000 per year. Notice that by investing more frequently (weekly rather than yearly) all three EPs can reduce their annual amount of savings and still reach the same goal. For this reason, it is critically important to invest any money immediately after paying expenses instead of waiting. Also notice that there is a greater impact on reduction of savings to the 30 year old than the 50 year old. For example, the 30 year old EP can save 15% less per year if he invests weekly, but the 50 year old EP can save only 8% less. The 50 year old EP still has a huge disadvantage because he still needs to save almost 30% of his income every year, whereas the 30 year old can reduce his savings to 3% of gross income.

Save More!
Going back to the original assumptions, let’s see how long it takes for the young EP to reach $2 million if he increases his savings rate. It takes 35 years to reach $2 million if he saves about 4% of his annual income. If he doubles his yearly investments to about $15,000, it takes about 28 years to reach the same goal, cutting his years of saving by 20%. Going further out, if he saves 20% of his income or $40,000 per year it would take only 19 years, which is almost half of his original time frame. He would be a multimillionaire before age 50. The mid-career EP can probably still increase his savings rate, but the 50 year old has very little room to do so.

Finally, let’s see the awesome results when combining the three “S’s of savings: the 30 year old EP (saving early) saves 40% (saves more) of his gross income or $80,000 per year and invests it on a weekly basis (saves often). He’ll be a millionaire by age 39, a multimillionaire by age 43. By age 50 his portfolio is worth over $5 million, and at age 65 his portfolio is valued at an incredible $25 million! So the choice is yours: drive a BMW or park next to one.

Setu Mazumdar, MD, practices emergency medicine in Atlanta, GA and is a member of the National Association of Personal Financial Advisors (NAPFA).
 

Comments   

# MDDavid Sack 2008-06-10 07:31
Personal finance experts need to stop trying to impress us with compound interest based on 10% annualized returns. This is NOT the historical norm. Not even if you include dividends. Certainly less if you remove broker fees. Only in great bull markets like the one from 1982-1999 does the market get 10%. Warren Buffet stated in his latest letter that in the 20th century the DOW went from 66 to 11497 this sounds great but is only 5.3% compounded annually. Warren himself begs people to not listen to pie in the sky advisors promising such returns. Please, please, please stop printing ridicululous claims about what people can EXPECT from the market. For the last 9 years the market has returned 2% even holding 30 years can NOT insure great returns. From 1968 to 1982 the market made very little gains. There are plenty of 40 year periods in the last 100 years with less than 5% gain. A great book on this is Irrational Exuberance by the economist Robert Shiller.
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# Setu Mazumdar MD 2008-06-10 14:20
Dr. Sack, I appreciate your comments. You are correct in your assessment that stock markets in the future may not return the historical averages of the past. Right now most advisors claim that future returns will most likely be less than past returns. However, no one really knows what future returns will be. The point of the article was not to predict what the future returns of the market will be. Rather, it was to show that you can accumulate wealth with simple savings and compound interest (as opposed to trying to find the next hot stock or timing the market). It's difficult to cover all angles from a short piece. As stated in previous columns I have written (see the second part of the mortgage article), the assumption that the stock market will provide stellar returns in the future may not hold true. From 1998-2007, for example, the annual return of an S&P 500 mutual fund was less than 6% per year. Most physicians unfortunately approach investing by looking at returns first rather than risk when in fact it should be the opposite. I wrote about this aspect in a previous piece as well (see the piece on risk tolerance). Changing the assumption to a lower investment return of 4%, the ending value at age 65 would still be almost $ 6 million. Of course, this assumes that individual investors stick with the plan when times are rough. Also, factoring in inflation and taxes will of course reduce these returns. Also, the return you need to achieve financial goals is different for each physician. The higher you set the bar,the higher your returns or savings rate needs to be (and the more risk you may need to take in a portfolio). For most investors, as their investment portfolio grows, they become more conservative, so achieving the historical returns (if they even hold true in the future) becomes far less likely. Again, the point of this whole exercise was to show the impact of savings. You also allude to point that I make to many colleagues: it is precisely because of risk that you expect to achieve larger returns in the equity markets. Notice that we EXPECT to receive higher returns in equity markets for taking risks, not necessarily that we WILL achieve those returns. One of these risks is that for long time frames the equity markets may return less than "risk free" assets or even have large negative returns. Thanks for your comments. Hope you continue to read my future columns.
Reply
# EM physicianEP in Dallas 2008-06-23 18:37
Great article. Even if the 10% rate isn't what we can expect, the principle (no pun intended) is what is important here: start early in your career with saving. I'm a newbie and trying my best to adhere to this.
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