Finance
by
Setu Mazumdar, MD
on May 27, 2008
“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.
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).
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