Tips, insights and information on general finance topics for better financial plans.
I thought about calling this post “The time value of money” or “The long term power of compounding” or “how to be a millionaire”, but the real thing I want to convey here is that for most people, one’s gut feel for the impact that both saving and investing as well as inflation have on our financial plans is apt to be wrong. This is largely due to the somewhat less than intuitive nature of compounding.
Many assume that if they have for example $10,000, invested at 5% per year and they add another $3000 each year, this will cause the value of the account to grow $3,500/year so in 20 years they will have $80,000. This way of estimating actually holds up OK in the short run, but in the long run it is way off as each year the “Return” is a percentage of the new larger value (or Principle) in the account.
The truth is a much better $125,731! Before getting too excited however, also consider inflation. This is a compounding scenario that you don’t hear many people talking about. The Federal Government generally tries to keep inflation in the 2-3% annual range. This is also compounded and not linear. The result? At 3% inflation, that $125,731 only has the purchasing power of $68,372.
So be cognizant of the compounding effect in your planning coming from multiple sources, some positive and some negative. This is a big part of what financial planning and retirement planning software should help you account for. More often than not it means that even modest saving and investing has a much bigger positive impact on your finances in the long run than you might expect.
Here’s the math if you’re interested:
V = I (1 + r/n) nt
V = future value
I = initial investment
r = interest rate (expressed as a fraction: eg. 0.06)
n = # of times per year interest in compounded
t = number of years invested