Seeing as this is technically a joint blog, it’s about time I took the mike away from Annette and posted something myself. She’s quite used to me rambling on about things that I’ve recently learned or found interesting, but unfortunately she often tunes out, with my valuable insights going unnoticed. Hopefully my rambling will be more appreciated by you, dear reader. Today, I’ll aim to demonstrate that becoming wealthy doesn’t require extreme skill, talent, hard work, or even good luck. Let me explain.
For most of my life, I have been reasonably frugal with my spending habits – saving up birthday money, doing thorough research before making a large purchase, and most importantly, avoiding the temptation to buy useless/overpriced goods (ahem, didn’t you buy a $70 bottle of moisturiser Annette?). When you save money today, you get to spend it in the future. However, most people (me included) don’t like the idea of saving a dollar today, only to spend the same dollar in a year from now. This is why we have interest – you stick a dollar in your savings account and over time you’ll get more than a dollar in return as compensation for waiting. Everyone is different in how much they like to postpone their spending now (otherwise known as ‘delayed gratification’), but I believe I am above average when it comes to waiting patiently for greater rewards in the future and this goes some way to explaining my frugality.
I think this deferred gratification characteristic is a huge factor that explains why some people are rich and some are poor, amongst other things. There were a series of famous studies at Stanford University in the late 1960s and early 1970s, where children were placed in a room with a marshmallow on a plate. They were told that they could either eat the marshmallow sitting on their plate right now, or they could wait a few minutes for the adult experimenter to come back and they would then have two marshmallows to eat. However, they would only get the second one if they hadn’t eaten the first while the experimenter was out of the room. I suggest you watch their adorable and funny struggles to avoid eating the marshmallow in this YouTube video. Some were able to hold off on the immediate gratification and got their two marshmallows, while others gave into the temptation and ate their marshmallow before the experimenter came back. It turns out that children that are able to delay their gratification in the marshmallow experiment go on to achieve higher SAT scores (i.e. better high school grades), had less substance abuse, were less likely to be overweight, responded better to stress, had better social skills etc. In other words, they lived more successful and happy lives.
Unfortunately, when it comes to making financial decisions, most adults behave the same way as those kids that ate their marshmallow immediately. Even worse, due to the availability of credit cards and other forms of debt, adults are able to consume way more than they can afford. Banks are happy to let you indulge in your immediate gratification, but they will charge you compound interest for it. You may remember the concept of compound interest from high school, and if you were a really good student, you may even remember the formula. Unfortunately, schools (at least in Australia) usually don’t hammer home the real world lesson enough and how it might change your life, so it’s up to Chris to pick up where the teachers left off.
Let’s say Annette was silly enough to go to a bank and take out a $20,000 loan to purchase a fancy car, with the interest rate being 10% per annum (this craziness wouldn’t happen under my watch). After 10 years, she’ll will owe the bank a whopping $51,875 (20,000 multiplied by 1.10 to the power of 10). In other words, Present Annette has stolen $31,875 from Future Annette. I imagine Future Annette would have a few things to say to Present Annette about that…
When you put it like that, compound interest sounds like evil – you’ll never be a wealthy person when you keep stabbing yourself in the foot like that. Fortunately, we can turn compound interest on its head and get it working for us via investing. If instead Present Annette had diligently saved up $20,000 by being thrifty and working hard, she could go and invest that in a diversified portfolio of shares, sit back and there’s a good chance she’ll end up with around $51,875 in a decade from now (the long term return on stocks has been about 10% p.a.).
That sounds great right? But it gets even better – what happens if you let that money grow for 20 years instead of 10? Since we doubled the timeframe, you might think that you end up with double that amount, or $103,750. Wrong! Due to the compounding nature of interest, an annual return of 10% will take us from $51,875 to $134,550. What if we get crazy and imagine Present Annette sets aside this $20,000 for 40 years? If she has the discipline not to spend any of it in those four decades, wrinkly old (60 years old to be exact) Annette would have $1,457,810*. Whoa, in other words, she’s officially a millionaire!
So Annette (and perhaps you) are probably thinking at this point, “wait a second, I don’t have anywhere near $20,000 right now, this is so stupid, why am I wasting my time reading this…”. Well, hold your horses, I was just about to get to that. Let’s say you could manage to be a bit more frugal or work a little extra so that you save $100 a week, or $5,200 in a year. After investing $5,200 each year for 40 years at 10% p.a., you’d end up with a ridiculous $2,301,481*. So you don’t need a huge pile of money right now, nor do you need to make huge sacrifices – you can get started on your journey to being wealthy right now just by saving a modest sum each week. I’ve found a good way to encourage yourself to save a bit more is to think to yourself, ‘I could buy this right now $100, or I can invest it and have a lovely $259 in a decade from now, assuming a 10% return’. In other words, try to be a little more considerate of your future self.
As I’ve illustrated, becoming wealthy isn’t as hard as everyone thinks. All it takes is some delayed gratification right now, and patience to let compound interest do the heavy lifting. And when you become wealthy, you can buy all the damn marshmallows you want.
*Note: To keep the analysis simple, I’ve ignored the effects of taxes and inflation. Inflation reduces how much stuff we can buy with each dollar in the future because the price of everything we buy tends to rise moderately, as you’ve probably noticed. If we assume inflation of 2.5% per year in the future, that $1,457,810 is worth $542,933 in today’s money, which is still impressively large compared to the $20,000 that was put in. Likewise, for the second example of investing $5,200 a year for 40 years, if we assume that your income and expenses rise in line with inflation, that $5,200 contribution each year will grow over time by 2.5%, which helps to offset the effect of inflation. You’d end up with a massive $965,270 in today’s money. Hence, even once we account for inflation, the core message still remains: compound interest will make just about anyone rich, given enough time.