Your Financial Best Friend: Compound Growth
Executive Summary:
Compounding growth is a fundamental principle of investing. Young lawyers who take advantage of it early in their careers stand to benefit the most from it. The power of compounding allows small investments to grow into large amounts of wealth over time. Lawyers who are able to start investing early in their career, not interrupt the compounding growth, and make consistent additional investments will experience the greatest growth. For young lawyers who want to begin investing but cannot invest an ideal amount of their income, they can commit to increasing their rate of investment by a small amount with annual raises.
The goal of financial planning is to achieve financial freedom. Financial freedom is the point in time when you no longer have to earn a paycheck to afford the life you want to live. Money is the tool that allows us to be financially free. Once someone achieves financial freedom they are in total control of their time. They can do what they want when they want. But it takes time to build enough wealth to be financially free. In a financial paradox, it takes time to build wealth that can then be used to give us more time.
If it takes time to have more time to enjoy our lives, would you want to start right now?
If so, it’s imperative to start the wealth-building process as soon as possible.
So why is time important to building wealth? The answer is compounding growth.
What is compounding growth?
Compounding growth is the process where money grows and then in the future, that initial investment plus the previous growth grows again. It’s a never-ending loop of rapidly increasing growth.
$1 that grows at 10% is worth $1.10 in the future. If it increases by 10% again, it is worth $1.21. The growth rate did not change, but in the second instance of growth, the investment increased by $0.11 instead of $0.10. Each time the investment grows, the amount it grows by increases.
Compounding growth is a difficult concept to visualize. Humans do not experience it often in life. Trees grow, but they do not grow increasingly faster after each inch they grow.
A simple way to understand compounding growth comes from a witty 3rd grader who wanted to earn a larger allowance. He told his parents that he wanted to take a pay cut in his weekly allowance. He asked if his weekly allowance could start at $0.01 with the condition that his weekly pay would double every week for the rest of the year. His parents agreed. How much could it cost?
After a week of successful chores, the next week of allowance was only $0.02. Still a great deal for the parents! By the 3rd week, his weekly pay was $0.04.
By the end of the first month, his weekly chores cost $0.08. After two months, his weekly allowance was now costing $1.28. The parents had only paid $2.55 for two months of work. They thought they had agreed to a fantastic deal. But the boy knew his work was going to pay off. After three months, their son’s weekly allowance was now $20.48. His parent’s started to worry.
They sat down and did some quick math to see how high the weekly allowance would be by the end of the year. The parents were shocked! It was going to get a lot more expensive. Do you know how expensive it was going to be?
If you guessed $1,000, that would be the boy’s weekly allowance after 4.5 months.
If you guessed $10,000, that would be the boy’s weekly allowance after five months.
If you guessed $100,000, that would be the weekly allowance after six months.
By the 7th month, the weekly allowance would be over $1 Million.
Did you guess $22 Trillion? That is how much the parents would be paying weekly at the end of the year.
That is the beauty of compounding growth. Initially, the results are not noticeable. But over time, the amounts grow faster and faster, even when the growth rate stays the same.
Let your money work for you!
In the real world, no one will double your money every week. It’s unlikely you will double your money every year. But even if you double your money every decade, you can still be very wealthy if you give it enough time.
Investing is a foundational component of every financial plan, and if done correctly, it can be the best thing you have ever done.
When you invest, you buy something that hopefully will be worth more in the future than what you paid for. Stocks, homes, and even your savings account benefit from compounding growth.
Historically, the S&P 500, an index of the stock value for the 500 largest U.S. companies, has grown at 10.5% annually since it began in 1957. Since 1992, home prices have increased around 5.3% each year. Today, a savings account will grow at an average of 0.06% per year. Future growth rates will likely not match historical growth rates, but they are useful to illustrate how compounding growth can be beneficial.
A young lawyer has done a great job at saving and has $300,000 to invest. They can choose to put their money in stocks, a home, and a savings account. The young lawyer decides to put $100,000 into each investment and decides to come back in 30 years to see how they did.
After 30 years, the $100,000 in stocks is worth about $1.3 Million. The $100,000 home is now worth over $470,000, and the savings account is now worth $101,815.
The stocks are worth 2.75 times more than the house, even though they grew by only 5% more each year. The stocks are also worth more than ten times the savings account even though they grew by only 10% more each year.
Compounding interest produces life-changing results when invested effectively, but it does involve risks. You should consult with a financial professional before investing.
Investing isn’t a one-time action
For the lawyer who had saved and then stopped investing, their results were great over 30 years. They turned a $300,000 investment into nearly $1.9 Million. But investing isn’t just a one-time action. Most lawyers continue to earn an income they can invest with each paycheck.
By continually investing each paycheck, young lawyers can accelerate the compounding growth of their wealth. Compounding growth works because you can contribute money today and hopefully the growth of your investment will compound over time. When your next paycheck arrives, you can then invest more and start the compounding for that contribution. The future investment won’t have as much time to compound, but it will still have plenty of time to grow.
A young lawyer received their first paycheck and is ready to invest. They saved $1,000 and can’t wait to get started. They place the $1,000 in a magic investment that will grow at 7% each year forever. The $1,000 initial investment required a strict budget to save up that amount, so the young lawyer is considering whether to keep contributing $1,000 each month or reduce that monthly investment to have more money to spend on other things.
They consider making $1,000 monthly contributions, $500 monthly contributions, and $100 monthly contributions for the next 30 years.
After 30 years, the $1,000 monthly contribution option would be worth over $1.2 million even though the lawyer would only invest $361,000. The $500 monthly contribution option would be worth roughly $600,000 with $181,000 invested. The $100 monthly contribution option would be worth around $130,000 after investing $37,000. If the lawyer only made an initial investment of $1,000 and never contributed again, their investment would be worth $8,117.
Making consistent investments can accelerate compounding growth over time.
Start early
It’s hard to start investing. As a young lawyer, you worked hard to get where you are today. You put in countless hours in law school and studied for the bar to achieve a high-paying job as a lawyer. Once you start earning a paycheck, you want to spend that money living a life you couldn’t dream of living in law school.
When you are young, retirement is a long time in the future. So naturally, many lawyers put off saving for retirement or investing until later. But compounding growth works best when you give it as much time as possible.
An investor who allows compounding growth to work for them over a long period will be much better off because most of the increases come in the later years.
If a young lawyer invests over 30 years at an average growth rate of 7%, they will have roughly double the money at retirement than a young lawyer who only invests for 20 years.
Two lawyers start working at the same time. Both lawyers are 25 and ironically have the same birthdays. They agree to retire at 65. The first lawyer decides to invest $1,000 every year for the first ten years of their career and then stop investing. The second lawyer spends most of their paychecks for the first ten years of their career living their dream life. After ten years, the second lawyer decides to get serious about retirement and start investing $1,000 each year until they reach 65. Do you know which lawyer has more money at retirement?
Did you guess the lawyer who started at 25 but stopped at 35?
If you did, you are right. At retirement, the first lawyer invested $10,000 but now has $112,000 to retire. The second lawyer invested $30,000 over their career and has $101,000 at retirement.
It can be challenging to start investing right out of law school, but it’s worth it, even if you can only contribute a small amount. The best time to begin compounding your wealth was yesterday, and the second-best time to start investing is today!
Life happens but don’t interrupt compounding growth
Life is uncertain. Sometimes surprise expenses happen. Once you start investing, you will have extra money to pull out in a financial emergency. If you are in a difficult financial situation, then, of course, you need to take care of that. But it does impact your future net worth.
Two lawyers begin working at the same time. They each want to retire and travel the world in 30 years. They agree to contribute $1,000 each year to save up for retirement, and they have found a magical investment that always grows 8% each year. After ten years, they have each invested $10,000, and now their investment accounts are worth $15,600.
One of the lawyers wants to take a sabbatical and needs $10,000 to pay for their time off but still intends to keep investing $1,000 each year. The other lawyer keeps investing their $1,000 as they agreed. At retirement, the lawyer who withdrew the $10,000 still retires with over $75,000 after contributing $30,000. The lawyer who kept investing and never had to take out any investments has $122,000 at retirement.
They both contributed $30,000, but the lawyer who didn’t withdraw $10,000 and interrupt the compounding growth has 62% more money at retirement.
In life, we can’t predict what will happen in the future, but we can prepare for it. Establish an emergency fund if you want to invest for the future and avoid interrupting compounding growth. The emergency fund is a savings account that is available at any time to pay for life’s unexpected expenses without interrupting the compounding process.
Young lawyer investing hack!
It is ideal if a lawyer can save and invest 20%+ of their income each year, but that is not always possible. We all want to live an enjoyable life, and most lawyers don’t want to limit their lives today for the future. If you can relate to this, here is a great way to have your cake and eat it too.
Start with an investment amount that you can afford today. Maybe that is only 3% of your salary, or you can start at 10%. It’s okay to start with an amount that fits your lifestyle. More is better, but that’s not always possible. Then commit to increasing your investments each year when you receive a raise. This strategy works well for lawyers because nearly every lawyer earns an annual raise.
Even a 1% increase each year in your investment rate can make a big difference!
If you make $5,000 each paycheck and invest 10% of your income, you invest $500 each paycheck. After a year, you receive a 5% raise, and you increase your investment percentage by 1%. Now you make $5,250 each paycheck and invest 11%. Instead of investing $500 each paycheck, you are investing $578. Your investment from each paycheck increases by $78, AND your income has also increased by $172. That is a win-win!
Let’s say two lawyers make $150,000 a year and begin their jobs together. Their firm gives lawyers a 3% raise each year. Each of them wants to retire in 30 years. They each can afford to start investing 6% of their income, and they also find a magic investment that always grows 7% each year. One of the lawyers wants, eventually, to invest 20% of their income, but they aren’t ready to do that right now. So they decide to increase their contribution rate by 1% each year when they receive a raise.
One lawyer keeps investing 6% of their income, and since their income always increases by 3%, the amount they contribute also increases by 3% each year. The lawyer who wants to invest 20% of their income will increase their contributions by 1% each year until they reach 20%. Like the first lawyer, the amount invested each year increases by a 3% raise, but the second lawyer also boosts their investment contribution by increasing their investment rate by 1%.
Over time this can be an effective way to boost your compounding growth!
The lawyer who invests 6% of their salary each year and receives an annual 3% raise retires with nearly $2.1 Million.
The lawyer who starts at 6% and slowly increases their investing rate to 20% does even better! In 30 years, they have been investing 20% of their income for 16 years. They would end up retiring with over $6.8 Million. That is three times more money at retirement than the first lawyer, while still increasing their spending money each year. Compounding growth and an increasing investment rate are so powerful that they could have retired after only 20 years and retired with over $2.2 Million.
Increasing the investment rate is one of my favorite strategies for young lawyers to implement. It allows them to add to their standard of living while also increasing how much they invest.
Final Takeaways
Compounding growth is the “eighth wonder of the world.” For young lawyers who understand how powerful it is, they can use this knowledge to accelerate their path to financial freedom.
It is a concept that investors like Warren Buffett say is “an investor’s best friend.” Its effect may not be noticeable for months, years, or even decades. But when it does start to take off, it will have an immense impact on your financial future.
So if you want to start using compounding interest to your advantage, here are a few tips:
Invest responsibly by investing in opportunities with a good chance of producing a high growth rate for a long time.
Invest consistently. Investing is a continuous process, not a one-time action.
The more you contribute regularly to your investments, the faster your investments compound.
Start early. If you haven’t started investing yet, start today!
Don’t interrupt compounding growth.
If you want to invest more over your career, increase your investment rate with each raise.
Compounding growth works best when you start early. Are you a young lawyer who wants to begin investing but isn’t sure how? Schedule a complimentary Meet & Confer today! Investment management is a key part of the Developing Financial Process. After learning about your financial goals and your comfort with investing, together we create a custom investment strategy. Included in this strategy is a saving/investing plan to make sure we are increasing the amount to invest without limiting your current lifestyle. Compounding growth is a powerful tool to achieve financial freedom. Start today!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.