---- — When planning their financial futures the number one goal that comes to mind for most people is retirement. Even for those who love their jobs and plan to work as long as possible, the time will come when they will leave the workforce and rely on their savings to help support a comfortable lifestyle.
In order to build a retirement nest egg that can last three decades or longer, most investors will need to adopt a disciplined program of saving a portion of their working income and allow those savings to grow. Most individuals accept the idea of sacrificing a little today to avoid living an unreasonably frugal lifestyle in their later years.
The accelerating trend of companies replacing pension plans that pay retirees a monthly benefit for life with 401(k)-type plans has shifted the responsibility of saving aggressively and investing wisely squarely onto the individual. To fulfill this responsibility a basic understanding of personal finance is essential.
One of the most important but least understood concepts in personal finance is compound growth, often referred to as compound interest.
Compound growth occurs when an investment is allowed to grow so that earnings are generated not only on the contributions made into an account but also on the earnings of those contributions. In other words, the investment earnings themselves generate earnings and are left to grow in the account. This creates an effect similar to a snowball rolling down a hill. Like the snowball that grows faster as it picks up more snow, an investor’s account balance grows faster as the years roll on because all interest, dividends and capital gains distributions that are reinvested also generate earnings. The results can be so dramatic they may be difficult to comprehend. Simple growth on the other hand is when the increase in the account value for each period (i.e. month, year, etc.) is a constant amount and is based only on the amount of contributions.
The three main engines that drive compound growth are the amount of savings contributions made into the account, the level of returns earned on the investment and the amount of time it is allowed to grow untouched. Assuming the investor starts out with a well thought out portfolio, investment returns are determined in large part by market forces over which we have little control. We can however exercise a measure of control over how soon we begin to save, how much we save and how long we work to allow those savings to grow.
A research study conducted by professors at the University of California and New York University published in 2011 in the Journal of Marketing Research concluded that “people have a deep and fundamental misunderstanding of savings growth” and as a result “grossly underestimate how much money can accumulate over the span of a typical career.”
Specifically, when presented with straightforward investing scenarios similar to those faced by an individual saving for a future goal, the study’s participants consistently used simple growth rather than compound growth in arriving at estimates of future account values. Unsurprisingly, estimates were drastically lower than actual results.
This study as well as earlier works published by other researchers further suggests that this failure to grasp the concept and effects of compound growth as it relates to their investments has serious implications for the quality of the saving, investing and borrowing decisions that Americans are required to make every day.
Next week we will demonstrate the power of compounding for building long-term wealth.
John Spoto is the founder of Sentry Financial Planning in Andover and Danvers. For more information, call 978-475-2533 or visit www.sentryfinancialplanning.com. This article is for general information purposes only and is not intended to provide specific advice on individual financial, tax or legal matters. Please consult the appropriate professional concerning your specific situation before making any decisions.