It’s been called the Eight Wonder of the World. Albert Einstein reportedly deemed it the greatest mathematical concept of our time.
Here’s how it works.
You take some money, say $1000, and put it into an account that earns interest. If you have an annual interest rate of 8%, after the first year you’ve earned $80. This gives you a total of $1080.
The second year, you get 8% interest again. Only this time, you earn 8% on $1080 (your original $1000, plus the $80 in interest you earned the first year). That means you’ll earn $86.40 in interest for year two, bringing your total to $1,166.40.
Do this for 30 years and without adding another penny to your savings you end up with over $10,000. Do it for 50 years and you’re close to $47,000.
If you add money to your original $1000 on a regular basis, then things really get interesting. Adding just $1000 a year (using the same 8% annual return above) will bring your 30 year total to over $132,000 and over $660,000 if you don’t touch it for 50 years.
While many investors are aware of the concept and benefits of compound interest, few give thought to the sinister forces of compounding costs.
An excellent article from the Consumerist shows how costs can add up over time . . .
"A 2006 study by Congress found that increasing fees by 1 percentage point results in you having 17% less money money when you retire.
In their example, put $20,000 in a 401(k) for 20 years and you end up with $58,000 if the fees are 1.5%. But if they were .5%, you would have $70,500. That's a lot of money. Increase the time to 35 years and what would be $220,000 drops to $163,000.
If you invest $1,000 at age 20 with an 8% return and 2.5% expense ratio, and just leave it there like that until you're 85, you will come out with $35,250, while your fund manager rakes in a cool $126,432."
That’s right, you’d be putting about 3.5 times as much money in your fund mangers retirement account than your own!
Two questions for you to ponder:
1. How are those seemingly small percentages you’re paying your 401(k) plan administrator and/or active mutual fund manager going to impact your ability to retire and the lifestyle you lead when you retire?
2. Are you doing more to build your nest egg or your money manager’s nest egg?
You can read the entire article from the Consumerist here.
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