$106,000 for coffee? Let's Talk Compounding
It can be hard to convince those who are reluctant to save to have the discipline to regularly contribute to an investment portfolio. Explaining the benefits of compounding and the potential benefits of delayed gratification to this same group of low savers is even more difficult.
Many people enjoy drinking coffee. Today, coffee is not your basic black with sugar but with the help of Starbucks and local coffee shops a premium cup of java is the norm. These cups of fancy coffee can cost upward of $5 or more. Meanwhile, a standard cup of home-brewed coffee costs about 10 cents.
How Much Is That Special Brew Really Worth?
The next time you are considering making a drive to the coffee shop, try to think about the possibilities if you were to save that money and buy a lower-priced version or try to limit your coffee shop days to two or three days a week. As you can see in the graphic below, that special cup of coffee really adds up over time.
By pocketing the $3.50 for coffee each day and investing it instead in a low-cost, diversified Roth IRA, you’d have an estimated $106,000 after 30 years. I don’t think anyone would pay $106,000 for coffee!
A Few Bucks Here, A Few Bucks There Can Pay Big Later
The bottom line is, small changes in financial behavior can have big consequences over time. Increasing your annual retirement savings contributions by as little as 1 percentage point can have a huge impact.
It’s smart decisions like these that can make the difference down the road, so you may buy that new car, take your entire family on vacation, or even retire a few years earlier than you had planned. And it’s not just about investing a little more early on. It’s also about not waiting until the last minute during the course of a year to invest.
Procrastinating Can Be Costly
A few years ago Vanguard looked into quantifying how high the procrastination penalty could be for an investor.* The research looked at investors who waited until the tax deadline to make their IRA contribution for the previous year. The result? Simply by waiting 16 months to make their annual contribution, clients could potentially lose $15,500 over 30 years.
“Compound interest is the eighth wonder of the world”
Albert Einstein said, “He who understands it, earns it … he who doesn’t … pays it.” The phenomenon of exponential growth as your returns build upon themselves over time is something deeply comforting to long-term investors.
Study after study has found that Americans aren’t saving enough for retirement. The median account balance among Vanguard retirement plan participants in 2015 was $26,405, which was down 11% from 2014.* I recommend a retirement goal of saving enough to be able to spend at a rate of 70% to 80% of pre-retirement annual income.
One way to encourage better financial habits is to continuously look at our spending through a compounding lens and to calculate how much our regular purchases may grow to over time. Time is the biggest advantage young investors have but staying focused on saving for something that’s decades away can be difficult.
Having simple, real-life examples may be just what you need to persuade yourself to make small changes now. Wouldn't you take home-brewed coffee over that $106,000 coffee any day.
*Stephen Weber and Maria Bruno, 2014. Are investors subjecting themselves to the “procrastination penalty”? Valley Forge, Pa.: The Vanguard Group.
*Vanguard, 2016. How America Saves 2016. Valley Forge, Pa.: The Vanguard Group.