How To Make The Power Of Compounding Work For You

by Silicon Valley Blogger on 2007-12-0318

Giving a mathematical paradigm a behavioral spin: my thoughts on making the first million.

We’ve all known how tough it seems to make the first few thousand bucks. It’s not an illusion. It *really* is hard to make the first few thousand. Or even the first few hundred thousand. Until finally the power of compounding kicks in and you reach a form of “critical mass” with your money — say a million dollars, after which point, the money becomes so much easier to make and grow.

This illustration originally came from the Fool’s article: Your First Million Is The Toughest.

To show how it works, here are a few charts that showcase how many years it takes to reach each $1 million threshold given that you regularly invest and earn a decent rate of return.

To go from $0 to $1 million:

Monthly Contribution 8% Return 9% Return 10% Return 11% Return
$100 52.9 years 48.3 years 44.5 years 41.4 years
$250 41.6 38.3 35.5 33.1
$500 33.4 30.9 28.8 27.0
$1,000 25.5 23.9 22.4 21.2
$1,291.66 22.8 21.4 20.2 19.1

To go from $1 million to $2 million:

Monthly Contribution 8% Return 9% Return 10% Return 11% Return
$100 8.6 years 7.7 years 6.9 years 6.3 years
$250 8.5 7.5 6.8 6.2
$500 8.2 7.4 6.7 6.1
$1,000 7.8 7.1 6.4 5.9
$1,291.66 7.6 6.9 6.3 5.7

To go from $2 million to $3 million:

Monthly Contribution 8% Return 9% Return 10% Return 11% Return
$100 5.1 years 4.5 years 4.1 years 3.7 years
$250 5.0 4.5 4.0 3.7
$500 4.9 4.4 4.0 3.6
$1,000 4.8 4.3 3.9 3.5
$1,291.66 4.7 4.2 3.8 3.5

That $1,291.66 number didn’t come out of thin air — it represents the current maximum monthly contributions available in a 401(k) or 403(b) account for most people. What these charts mean is that you can go from $0 to $3 million in somewhere between 28 and 35 years with a little bit of determination to take advantage of the opportunities you have available. Most of that time is spent getting to that first million. Once you hit that milestone, compounding really takes over to help you reach your ultimate goal.

Here’s a handy calculator that will tell you how your savings compound through time. And for more examples, you can view this table.

These examples show you how easy it starts to get after you make that first million: beyond the first million, the time it takes to make subsequent millions becomes shorter and shorter. The power of compounding is awesome to behold since it demonstrates how big an effect even small simple contributions make to our bottom line. Not a surprise that Einstein designated it as the “8th Wonder Of The World”.

Taking Another Look At The Million

But wait! This power can only keep working under a few assumptions and requirements:

  • You make consistent contributions to your investments, thus continually growing your nest egg.
  • You live below your means.
  • You don’t get tempted into spending money as fast as it grows.
  • You don’t live in an area with an absurd cost of living.

Given these assumptions, some will claim that after making that first million, it’s not going to get any easier. They’ll say that with all due respect to the power of compounding, a million dollars doesn’t go as far as it used to. And sadly or shockingly enough, there are millionaires out there who are complaining they don’t feel rich with what they have, what with all the expenses they’re now saddled with since finding their “good” fortune.

A million is no chump change but given all the material temptations and premature confidence that one may experience after that special seven figure milestone is reached, who knows if this may actually be the point when people begin the struggle to hold on to what they have. That struggle is due to human nature kicking in, encouraging us to increase our material appetites alongside our wealth. Isn’t it also the case that we often like to “reward” ourselves after achieving big goals — and what other reward is there but to relax our fiscal discipline just a bit and maybe yield to more than a few pricey temptations?

So in this regard, I’d argue that the challenge doesn’t stop with acquiring your first million because if you don’t watch that million carefully, no amount of compounding will neutralize the effect of wayward spending. If your lifestyle grows as fast as your money, you’ll find that making and growing that money will always be tough, even a struggle. Why do you think some people (especially those in more expensive parts of the world) feel poor, even if by world standards, they’re far from it?

While on our way to building our net worth, it is worth reminding ourselves that nothing spurs the growth of wealth along more than the power of compounding, but you’d have to leave it to do its job uninterrupted.

Copyright © 2007 The Digerati Life. All Rights Reserved.

{ 12 comments… read them below or add one }

thewild1 December 3, 2007 at 3:56 pm

the “uninterrupted” part is probably the hardest. great article.

Mrs. Micah December 3, 2007 at 5:08 pm

Waaaah. I want my first million for free. :P ;)

Very good points about feeling entitlement and raising our standard of living. It’s hard to find balance between enjoying what you have and not having anything…

david December 3, 2007 at 5:39 pm

Those are great charts there for determining how long it takes to get your first million. Holding on to that million can be a struggle too because of impulse.

Tezza December 3, 2007 at 7:17 pm

Really enjoyed the charts. You make a valid point when you say: “And sadly or shockingly enough, there are millionaires out there who are complaining they don’t feel rich with what they have” The challenge I think is to aspire and achieve your goals while knowing that it’s not the actual goals or money that make up a “wealthy” life.

hank December 4, 2007 at 12:36 am

Just a few short 35 years later, and at that time we’re forgetting the 3% inflation rate – I suppose that’s why it is good to have 3 or 4 accounts… :) Nice post though, really puts it into perspective! Here I come lottery!!

Madison December 4, 2007 at 9:09 am

The most exciting day was when compounding became the biggest earner in our household. Now, we’re a “triple-income” family! Contributions are a drop in the bucket since the compounding took off.

Silicon Valley Blogger December 4, 2007 at 11:41 am

I like Madison’s description of considering compounding as the third earner the household! That’s a great way to look at it.

If you’ve got a large enough savings and investment pool, you may indeed claim you are a triple income family :).

The amazing thing is when that invisible third earner makes the money for your entire family.

Brip Blap December 4, 2007 at 8:38 pm

I didn’t know whether to be cheerful or depressed after reading this. I know it will be hard to make that first million, but then again I’m looking forward to the downhill slope after I reach it :)

LC December 5, 2007 at 9:36 am

It would be interesting (and perhaps more encouraging) to repeat with a monthly contribution of $1708.33, which would be contributing the max to both a 401k and a Roth (16.9 years at 11%). You could also double this to account for 2 earners doing this (11.8 years). In that case, you are creeping into the area where most people aren’t disciplined enough to save that much, but it would show that it can be done if you are willing to make sacrifices.

Jacob December 9, 2007 at 12:23 pm

Ah, the beauty of logarithms. Actually it’s as hard to go from $1 to $2 as it is to go from $1000000 to $2000000 if compounding is the only method (e.g. no contributing savings).

One motivational problem when monthly contributions start matching the compound rate is the temptation to become less serious about contributing. Happened to me, but I’m getting back on track.

Fiscal Musings December 9, 2007 at 7:05 pm

You always hear that the first million is the toughest, but this kind of puts it in perspective. I would suggest though that as you get closer, you not only have the power of compounding, but you’ve hopefully learned a few things along the way that allows you to increase your returns.

Dividends4Life January 8, 2008 at 7:31 pm

Put another way, each day you wait, the less likely you will be able to meet your financial goal. There is no substitute for time.

Another great article!

Best Wishes,
D4L

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