Thursday, January 4, 2007

The Power of Compounding

This article points out the power of compounding. Someone who saves $100/month for 10 years between the ages of 22 through 32 and then stops saving has more money at the age of 64 than someone who waits until the age of 32 to begin saving at the same rate and saves for 30 years. (Assuming 8% interest).

Not arguing with the math, but rather with the practicality. When I was in my 20's, $100/month would have been a significant hit to my budget, whereas now it's not such a big deal. Not only has my income increased in real terms, but there's been a good deal of inflation since then, including a few years of double-digit inflation.

These articles point out the power of compounding when it comes to savings, but leave out the power of compounding when it comes to inflation. Even at today's more modest inflation rates the compounding can be significant. At 3.5% annual inflation, the value of a dollar is halved in 20 years.

In the example given, the person who saved in his 20's was saving more valuable dollars than the person who waited until his 30's to start.

My point is not against saving, nor is it against saving while at a young age. Rather my points are that (1) effects of inflation can't be ignored and (2) your savings rate should not stay level over long periods of time.

Start young, save what you can, and adjust your savings rate for inflation and improvements in income. And hope that the earnings on your investments keep ahead of the inflation rate.


Chris B. said...

Great post. I am always amazed when I hear about the power of compounding, but I never thought about inflation. You are exactly right. It is not realistic to think that someone at age 22 and someone at age 32 would be saving the same $100 per month. In most cases, the 22-year-old would save less, the 32-year-old would save more, or both. I will have to crunch the numbers and see what happens if the 32-year-old saves at a higher rate because of inflation and a higher salary.