The Snowball Effect and Personal Finance

OLYMPUS DIGITAL CAMERADave Ramsey often talks about the debt snowball – his strategy for eliminating debt, where you start by paying off the smallest debt while you pay the minimums on everything else.  You then take the money you were paying for the smallest debt, add it to the minimum payment you were paying for the second smallest debt, and pay that one down.  You continue this process, always adding the money you free up by eliminating a debt to attacking the next biggest debt.  Like a snowball rolling down a hill, you pick up more and more momentum until you are finally done and can call the show and yell to the hills, “I’m debt free!!!!”

Really the snowball effect goes beyond debt repayment.  Think about rolling up a snowball right when the temperature is about 34 degrees F – just perfect since the snow melts just a little and it sticks.  When you start you need to gather the snow together into a ball, then you start rolling.  When you first start, the snowball gets a little bigger each time you roll it over, but it really doesn’t seem to grow that fast.  At some point, however, it reaches a critical mass where with every rotation of the snowball it picks up ten to twenty pounds of snow.  Then the next time it picks up fifty pounds of snow.  Before you know it, the snowball is too heavy to move anymore.

If you are investing money, you see the same effect.  When you first start out, sending maybe $200 per month into an investment account, it seems to take forever for anything to happen.  After a year or so you finally have enough money to buy your first stock or invest in your first mutual fund.  After a couple of years, you look at your statement and see that your investments have only returned a couple of hundred dollars.  Maybe you look at your 401k balance after five years and see that it is actually worth less than the amount of money you put into it.  With a balance of $12,000 or so, you can’t see how you will ever have the $2M you’ll need for retirement.

Then, after several years of putting money away consistently, there is a stock market rally and your portfolio doubles.  You see that you now have $100,000 in your account.  You have a couple of more good years, and you see the balance grow by $20,000 the next year, then $30,000 the next.  You may see a decline the third year, but then in your four and five you regain all that you had lost and then some.  Like a snow ball gathering mass, each time that it goes around the amount of snow it picks up increases.  Finally, in the years before retirement, you’re gaining an average of a quarter million dollars or more from your 401k each year.

Going into debt, and then getting out of it, is also like a snowball.  When you first start to take on debt, the amount of interest you are paying is small, just like the small amount of snow your snowball gathers when it is only the size of your fist.  If you want to, you can quickly pay the debt off and be done with it.  You can also easily sweep off the small amount of interest you gather, keeping your debt from growing.  If you have a couple of unexpected expenses, however, and let your snowball add mass, the interest payments – the amount of snow your snowball gathers with each rotation – start to grow.   At some point, it seems like no matter how much extra you pay into the debt, it just keeps growing because the interest payments get so large.  The snowball gathers tens of pounds with each revolution, threatening to bury you alive.

When you’re trying to the pay it off, it will also seem at first like you’re making no progress at all.  Each time you pay a little, it seems like you’re taking a bucketful of water out of the ocean.  As you reduce the debt, however, the amount of interest you pay will be a little less, allowing you to pay back a little more of the debt.  Keep chipping away at it, and before you know it you’ll have it back down to a manageable size where you can dispense with it at last.

So remember the snowball effect when you’re saving and investing.  At first it will seem like nothing is happening for several years as your little snowball begins to grow.  At some point, however, your snowball will reach the point where it gathers a significant amount of snow as you push it along, and that amount will increase with each revolution.  Before you know it, the rate of growth becomes exponential.

Going the other way and trying to pay off debt, it will seem at first like you’re making no progress, but as you strip away your snowball, it will gather less and less snow, until finally it becomes so small you can crush it in your hand.  Also remember that the rate of growth can be deceptive as you start to take on debt.  It can suddenly go from no big deal to a world crushing ball of snow the size of your house if you let it get out of control, because the bigger it is, the faster it grows.

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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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