Compound interest confuses most people. very few people can figure out what their car payment will be, the amount of interest they will pay on their house, or what their bank account will be in ten years. Fortunately, for the last question, there is a simple method called the “Rule of 72.”
The Rule of 72 goes like this:
Take 72 and divide by the interest rate. That will give the number of years it will take for your balance to double at that rate. After that, just keep doubling to find you balance.
For example, let’s say you invested $2000 in a mutual fund when your child was born for his retirement (a very smart thing to do, as we shall see). Stocks have returned between 10-15% since about 1900. Assuming this rate of return remains (Let’s assume a 12% rate), your child’s account will double about every 72/12 = 6 years. This means the account will double at about age 6, 12, 18, 24, 32, 38, 44, 50, 56, 62, and 68, or 11 times. 2*2*2*2*2*2*2*2*2*2*2 = 2048. This means that your $2000 will be worth 2048*2000 = $4,096,000 at age 68. Leave it in another 6 years, and it will be worth $8,192,000. This means that you can effectively provide for your child’s retirement with an investment of about $5000 (worth $40M at age 68) when that child is born (assuming you can keep him from spending the $40,000 he will have at age 18 on beer in college).
Let’s say that instead of investing, you leave the money in a CD yielding an average of 3%. Using the rule of 72, one sees that it will take 72/3 = 24 years to double. The account will therefore double at age 24, 48, and 72. The value would therefore be $2000*2*2*2 = $2000*8 = $16,000. Comparing the figures, one can easily see the importance of investing in stocks for long-term investing. For the sake of “security” one is giving up over $4 million by not investing. And this assumes no inflation.
Finally, any regular reader will know that I have been harping on how terrible Social Security is. Currently, after working for about 45 years, one receives about $1200 per month for as long as one lives. If one dies, all of the money goes away. Assuming you live to be 75 and start receiving Social Security at age 65, this would amount to about 12*$1200*10 = $240,000 in benefits. If you were instead able to take your first year’s worth of payments (about $6000 for a $50,000 per year job) and invest in a mutual fund, your money would double every 6 years, at age 24, 30, 36, 42, 48, 54, 60, and 66. Your balance would then be 256*$5000 = $1,280,000!
Note this is just your first year’s payments – not including the other payments of $5000 per year made the rest of your working life. This money would also go to your hiers if you died. If you feel this is as much of a crime as I do, please tell your Senator.