There is a quotation widely attributed to Albert Einstein to the effect that “Compound interest is the most powerful force in the universe”. Now, there is disagreement about whether or not he actually said that officially, but the point is that compound interest is indeed a very powerful tool.
Most kids have heard the story of how much the money paid to buy the island of Manhattan would be worth today had it been allowed to accrue interest. I found it and copied it from a website (http://www.stretcher.com/stories/05/05jun27d.cfm) It goes like this:
“In the early 1600s, the American Indians sold an island, now called Manhattan in New York, for various beads and trinkets worth about $16. Since Manhattan real estate is now some of the most expensive in the world, it would seem at first glance that the American Indians made a terrible deal. Had the American Indians, however, sold their beads and trinkets, invested their $16 and received 8% compounded annual interest, not only would they have enough money to buy back all of Manhattan, they would still have several hundred million dollars left over. That is the power of compound interest over time.”
Now obviously, our modern banking system did not exist in the 1600’s, and even if it did, it is unlikely that the natives would have put their beads and trinkets into an 8% interest bearing account.
However, the lesson and the point here are still relevant. Given the power and effectiveness of compound interest, why wouldn’t you use that to your advantage? A little bit of money in your 20’s will turn in to a LOT of money in your 60’s, even after the eroding effect of inflation.
In addition, it’s easier than ever to get good rates of return on relatively safe investment vehicles. And excellent example is the 401 (k) account. It’s tough to find a much easier way to invest in the equities markets with pretty low risk. Many employers will even match a percentage of your income going into such an account. That means if you don’t use the benefit, you’re essentially giving away part of your salary! Why leave that money on the table? If your employer wants to give you money, why wouldn’t you take it! As an example, a common scheme is to have the employer match your contributions dollar for dollar up to 4% of your income. In other words, if you invest 4% of your in your 401(k), your employer will match that same amount. That’s like a 4% raise in salary. Sure you can’t access it now, but that’s actually good, in the sense that you tap into “the most powerful force in the universe”.
You can divide up the 401(k) contributions as you see fit. You can play it relatively safe and buy lower-interest money market accounts (similar to CD’s you could buy at your bank), and government bonds. Or you can go a bit more aggressive and buy stocks and bonds of various degrees of risk. Generally these stocks are bundled in the form of mutual funds. Mutual funds are essentially a basket of stocks bound into a single instrument, and they often have a common theme.
For example, you could get a “small cap international fund”, which means you are investing in stocks from a large number of small countries from all over the world. You might own stock in some small bicycle company in St. Petersburg Russia, or a small fishing company in Japan. This would be a relatively high-risk fund to own, but that also means there’s the potential for very large gains. If you’re investing over a term of several years, you can probably stomach some extra risk in the short term, because in the long term such a fund usually balances out.
On the other side, you could invest in a “large cap domestic” fund. This means you would own stock in lots of very large companies in the US. These would likely be names you know: companies like Disney, Ford, IBM, General Electric, Hershey. These companies are stable, so your investment is pretty safe. However, you also know that they are unlikely to see their value triple overnight, like that St. Petersburg bicycle company could, too.
There are also funds that concentrate on particular areas of an economy. You could get a fund of nothing but tech stocks. Or Health Care stocks. Or Financial industry stocks. Or any of hundreds of others. In the end, most people tend to invest of a blend of all of these to “diversify” their portfolio. That way a crash in one sector would be balanced out by the others. Not “putting all your eggs in one basket”, so to speak.
The great thing about your 401 (k) is that it’s tax-deferred. What that means is that you don’t pay tax on that portion of your income until you take it out at retirement. What difference does that make? Well, what it means is you get to take advantage of “the most powerful force in the universe” with money that would otherwise have been taxed away from you. In other words, you take your money, let it build interest on itself for 30+ years while you work, tax free. Then you pay tax when you actually make the income from it.
There are other great investment tools that work the same way. One is the IRA (Individual Retirement Account), which works much the same way. Since 401(k) accounts and IRA accounts both have maximum allowed annual, I would highly recommend doing both if you can afford it.
Another great retirement tool that many people don’t think about is whole life insurance. Yes, really, life insurance. You can buy life insurance policies that build cash value, are invested like mutual funds, can be withdrawn from like loans, and still pay the death benefit like real life insurance.
Annuities are tools you can look into to make sure you don’t outlive your income. An annuity is something that you pay into up to a certain age, and then it pays out when you decide to switch it over, and based on how much you put in, and some actuarial accounting, the company will determine your monthly payout, which you draw as long as you live, even if you live to 200 years old. Obviously, the company goes by average life expectancies to work out how much to pay based on what you have in, and on some people they “win” because they die early, and on others they “lose” because they live to 110, but the law of averages ensures that overall they should be OK.
The common theme with all of these investment tools is that they let you, the customer, take advantage of compounding interest. A little money now, along with some sound investment strategy, can turn into a LOT of money later. Why not let it work for you?