Why should I be investing at a young age?
I hear this question a great deal from my friends and a quick search on the internet finds it echoed frequently in online forums. This makes me wonder, with all this literature out there, how come we don’t see more savings from young professionals? I believe much of the answer can be explained by opportunity cost miscalculations (more on that later!), but I think a lot of people just simply don’t consider the numbers in visual terms. Hopefully I can help with that.
I imagine most of you are familiar with the term compound interest; earning 5% on $100 one year means the next year you’re earning on $105, and so on and so forth. I think the hardest part about compound interest is trying to visualize just how long it takes to make it worth something. Coming back to the $100 example, consider this. Annualizing at 5% a year, it will take you about fourteen years to have $200. Why is that? Compound interest is a geometric series – a progression in math where a sequence of numbers is multiplied by a common, fixed number which in this case 5% – so earning 5% on $100 nets you $105, and then next series will be the sum of $100 times 5%, plus $5 times 5% which is $.25. Then the next series will have all that plus $.25 times 5%. Conceptually, starting with $100, you’re adding $5 plus smaller and smaller increments with each compound. If we weren’t using compound interest, it would take you exactly twenty years (100/5) to get an extra $100 – but adding those smaller and smaller increments shaves a cool six years off that total. The power of compound interest is real! Geometric series are a pretty neat thing to think about; however, understanding them, for the purpose of this post, isn’t necessary. And no, there won’t be a quiz later. So how does compound interest apply to you? Continue reading