The majority of millennials today are wary of investing in the stock market, and I can’t blame them at all because I was one of them. We saw what the great recession did to our country as a whole.
Millions of people watched helplessly as their investment portfolios were cut in half in just over a year as the stock market tumbled. And many of those people sold their investments as the market approached bottom in March of 2009 because they just couldn’t bear the losses anymore. It was brutal.
I feel so badly for those who had to sell because the stock market has enjoyed a tremendous rally since that time and consistently reaches new highs seemingly every month. If those investors would have been able to stay the course, continued to invest and weathered the storm, they would be enjoying tremendous wealth today. This is much easier said than done of course, but the history of the stock market shows us that the market can be quite volatile in the near-term, but marches relentlessly upward over the long-term.
“The Dow Jones Industrial Index started the last century at 66 and ended at 11,400. How could you possibly lose money during a period like that? A lot of people did because they tried to dance in and out.” – Warren Buffett
The Big Risk With Safety
Many people simply do not want to take the risks associated with the ups and downs of the stock market and would rather keep their money in cash or in a “safe” savings account. The problem with this plan is that it does not protect you from the sneaky money-eating monster, inflation.
Each year, the cost of goods and services goes up. The amount it increases is called inflation which has historically averaged around 3% per year. I’m sure you’ve heard your grandparents say “when I was a kid it cost 50 cents to go to the movies.” It costs at least $9 today. That’s inflation. Inflation is the reason why Subway no longer offers five dollar footlongs. Baseball legend Babe Ruth made $80,000 during the 1930 season, which is the equivalent of $1.1 million in 2017 dollars. That’s inflation.
Things cost more money as time marches on. Inflation tells us that a dollar will be able to buy more today than it will five years from now.
And if our money does not grow faster than the rate of inflation, we are essentially losing it each year. This is where the stock market saves the day.
The Magic of Compound Interest
The stock market, for all its ups and downs, has historically averaged around a 6.8% annual rate of return after accounting for inflation. Not only does the stock market outpace inflation, but it can also provide investors with compound interest.
Compound interest occurs when the interest on your investments earns interest on itself and creates an exponential growth effect over time. Albert Einstein called compound interest the eighth wonder of the world. And to quote Mr. Buffett again, “My wealth has come from a combination of living in America, some lucky genes, and compound interest.”
Let’s look at a quick example. If you invest $1 and earn 6.8% interest on your money, after one year you will have $1.07. In year two, the 6.8% interest is no longer applied to the initial $1, but instead to the $1.07 amount from year one. So after year two, you’ll have $1.14.
That doesn’t seem significant, but consider that after year 10, your $1 will have grown to $1.97, or almost double the initial investment. After year 20, that $1 will have grown to $3.88 or almost quadruple.
The key to unlocking compound interest is to start investing as early as possible to allow this powerful snowball effect to take place. It is not about timing the market, but rather time in the market that counts. Let’s explore further.
Worried Walt and Compounding Carole
Let me tell you a story about two best friends, Worried Walt and Compounding Carole. They are both 25 years old. Worried Walt does not trust the stock market and does not want to take any risk with his money. Compounding Carole on the other hand, understands the value of investing and outpacing inflation, along with the incredible benefits of compound interest.
So Worried Walt saves up $5,500 this year and decides to keep it in a 1% savings account and will not touch it until he turns 55. First off, let’s congratulate Walt for not spending this money and losing it forever.
Unfortunately though, Walt’s savings account will not outpace inflation and his inflation-adjusted balance will go down over time as a result. The money eating inflation monster feasted on Walt’s savings over the years. (Cue the sound effect when Pac Man gets eaten by a ghost.)
$5,500 one-time contribution in savings account for 30 years = $3,067.35 in today’s dollars
Graph: calculator.net
Compounding Carole, on the other hand, decides to put her $5,500 in a stock market index fund with an average annual return of 6.8% after inflation and leaves it alone for 30 years. That $5,500 will grow to an inflation-adjusted amount of almost $42,000. Not bad Carole!
$5,500 one-time contribution into stock index fund for 30 years = $41,579.29 in today’s dollars
Graph: calculator.net
See the green interest line above? As time goes on, the interest earned on your investment accumulates more each year due to compounding and creates an exponential (not linear) growth effect.
Alright Walt, time to step your game up. Walt decides to save $5,500 each year for 30 years in his savings account, again, instead of investing. I admire his plan to save consistently year after year – let’s see how he did. After 30 years Walt contributed $165,000 but unfortunately ended up with less than that amount at the end.
$5,500 each year for 30 years in a savings account = $125,283.31 in today’s dollars
Graph: calculator.net
Carole is inspired by Walt’s consistent savings method and decides instead to save $5,500 each year in her stock index fund until she turns 55.
$5,500 contribution each year in stock index fund for 30 years = $530,577.75 in today’s dollars
Graph: calculator.net
Carole will end up with over $400,000 more than Walt simply due to her decision to invest in the market. As time marches on, Carole’s money works harder and harder accumulating wealth without her lifting a finger. Sorry Walt.
Now, $5,500 is an admirable amount to save each year. That is a 14% savings rate for someone who earns $40,000 in take-home pay. But I challenge you to dream bigger.
So Carole reduces a few of her unnecessary expenditures and is able to save 40% of her take-home pay each year – which equates to $16,000, assuming she never gets a raise. Let’s just see what happens if she throws that money in the stock market each year.
$16,000 contribution each year in stock index fund for 30 years = $1,543,498.92 in today’s dollars
Graph: calculator.net
Now we’re talking! Carole will end up with over $1.5 million by consistently putting her 40% savings in the market and utilizing a set it and forget it approach.
The Choice Is An Easy One
As you can see, by not taking any risk, you are actually putting your savings in tremendous danger when you account for inflation. If your money does not grow faster than inflation, it loses purchasing power. Walt found this out the hard way.
Savings accounts can be a useful tool to hold money that needs to be accessed quickly, like your emergency fund or for any short-term goals such as buying a home or saving for a wedding, but that’s about it.
The stock market simply offers the greatest risk-adjusted return on your money and is a truly incredible wealth building tool. The power of compounding is real and is more effective the earlier you start investing.
Remember, the longer you are invested the greater the compounding effect (think of that green line) – so while the best time to get started was yesterday, the second best time is today. Your money will work tirelessly for you as time marches on, enabling you to focus on the more meaningful things in life.
It is also important to put new money to work in the stock market on a consistent basis. This way, if the market does go down, (which it will do many times) your contributions will buy fresh shares at lower prices which helps smooth out the volatility and provides more substantial long-term growth for your portfolio.
So by consistently investing in the market through its hundreds of ups and downs and doing so wisely through a proper mix* of low-cost index funds (domestic, international, bonds), you will build tremendous wealth over time.
And I promise, your future inflation-protected self will thank you every single day for making the simple choice to invest your money in the stock market instead of hiding it in a “safe” savings account.
The Personal Finance Playbook 