A lot of investment publications tout the power of compounding. Basically, the way it works is the longer you have money invested, the longer you earn interest or other investment returns on those very same investment returns.
In one example provided by Investopedia, one twin starts investing $100 a month at age 25 and another waits to age 50 to start saving. The second twin seeds his investments with $5,000 and then adds $500 a month. When their both 65, the twin who has been saving just $100 a month has a lot more stashed away than the sibling who has been socking away five times as much for the last 15 years.
At a 4% average rate of return, the first twin will have $151,550 on an investment of $54,100 and the second twin $132,147 on an investment of $95,000, close to twice as much. The difference would, of course, be even greater at a higher rate of return.
Real vs. Nominal Dollars
This is very impressive and seems to indicate that everyone should start saving at as young an age as possible in order to benefit from the power of time and compound interest. But I’ve started wondering if it’s a bit misleading or exaggerated since a dollar (or $100) 40 years ago was worth a lot more than a dollar today. In fact, according to one website, a dollar in 1984 has the same purchasing power as three dollars today.
So, going back to our twins, the power of compounding and starting early would not look quite as good if the first twin had invested approximately $81,000 in real (as opposed to nominal) dollars. I got to this figure by multiplying the $54,100 invested by 1.5, reasoning that $100 invested 40 years ago would be worth $300 today, but $100 invested last year would only be worth a bit more than $100 today. (An economist or financial analyst could provide more exact calculations.)
Of course, we also need to adjust the second twin’s $95,000 investment for inflation. Using the same formula, but with less inflation over 15 as opposed to 40 years, the second twin’s real investment would be about $118,000 in today’s dollars.
But What’s the Best Use of the Funds at the Time?
So compounding still works. The first twin ends up with $151,500 on an investment of about $81,000 as compared to the second twin who has $132,147 at age 65 on an investment of about $118,000 in real dollars. The difference is just not quite as great as it looks using nominal dollars. And the second twin had the use of their funds during the 25 years the first twin was saving, years in which they may have needed those funds, for instance to raise a family for pay the mortgage on a home.