I recently read Jim Collin’s new book, The Simple Path to Wealth, and there’s one section of the book that I wanted to write about because it’s something that very few people understand or even realize. Jim also writes about this idea on his website, and you can read about it here.
Saving is exponential for this reason: It’s the idea that every dollar we save earns more dollars, which in turn earns more, and so on and so forth. This is known as compounding. Most people see the negative side of this, through debt, where the interest owed keeps growing the longer the balance remains. Rather than let compounding work against you, why not take action to let it work for you?
I love this concept because it illustrates how your money works for you, rather than you working for money. This is an important concept to early retirement because the expectation is that, over time, the account balances will actually grow even though you’re withdrawing money from them. The key to this is to be flexible in your withdrawals, adjusting for market performance.
The concept of compounding is the reason why you should try to save as much money as you can. For every dollar you don’t spend, you can save it. In turn, that saved dollar will compound over time and eventually turn into $2, then $4, and so on. This is calculated using the Rule of 72. To determine how quickly your money will double, divide 72 by the interest rate/rate of return and that will calculate the number of years until your money is doubled. For instance, if the rate is 9%, it’ll take 8 years for your money to double. And that’s without adding another cent!
Because interest rates on savings accounts are so low — and actually negative when you factor in inflation and income tax — your best bet for a real rate of return is in the stock market. But you need to make sure that you don’t need that money for 5-10 years since the market fluctuates often (as we saw with Brexit). For short-term savings, a bank account is still your best bet since the importance lies in liquidity and not growth. Bond funds are your other option, if you’re absolutely determined to have the money invested in some form.
Compounding is a powerful force and benefits those who are young, with time on their side. As they say, the best time to start was yesterday and the next best time is today. Don’t waste any time in letting your money work for you.