Compound Interest, Opportunity Costs & the Time Value of Money
Compound Interest, Opportunity Costs & the Time Value of Money are all common and related personal finance terms you are likely to have heard in the past. They are related terms that all end up emphasizing one thing: saving money early is worth a lot more than saving money later. Using historical average stock market returns and factoring in inflation, money saved and invested for 40 years is worth almost 15x as much. That means people who were able to save $10,000 in their early twenties would have that amount of money turned into $150,000 for retirement if they retired in their sixties. While it is common to hear about people spending every penny they had on things like travelling in their twenties and not having a single regret, the opportunity costs of doing so are high. Living life while you are young is important and not every decision should come down to finances, but saving at least a little bit during this time can have huge benefits in the long run. To understand why, we first must understand the previously mentioned terms:
Compound Interest: Compound Interest is interest (earnings) on top of interest (previously earned money). For example: If you invested $100 in 2020 and earned a 10% return, you would have made $10 and end with $110 invested in 2021. If you earned another 10% return in 2021, you would have made $11. That extra $1 is due to compound interest. In order for compound interest to happen, the gains of an investment must be reinvested. If you had a 10% return on $100 but then took the $10 instead of having it invested, compound interest would not occur.
Time Value of Money: Because of compound interest, a dollar now is better than a dollar later. This is the Time Value of Money. I will show some specific examples further down, but as I previously mentioned: money invested and compounded for 40 years was worth almost 15x more than the original amount. That means if you were given $10,000 when you are 20, it is worth 15x more than receiving $10,000 when you are 60 (including factoring in inflation).
Opportunity Costs: Opportunity Costs are the loss of potential gains from one option due to choosing an alternative option. Due to the Time Value of Money and a dollar now being much more than a dollar later, spending money (rather than saving and investing) has a much larger opportunity cost than just the dollar spent. For example: I am 20 years old and just got my first job not to long ago. I managed to save $10,000 and figured I would go travelling. While the vacation might cost $10,000, if I retired when I was 60 it would have actually cost me $150,000.
Spending money and enjoying life is important, but it is also important to think about the actual opportunity costs of the money being spent. Is 1 vacation when you are 20 worth 15 vacations when you are 60? Only you can decide if it is worth it for you. Like everything, moderation is also important for spending and saving: maybe 1 vacation now is worth 15 later, but 2 or 3 a year right now is not worth 30-45 later. Is going out every weekend throughout your 20’s worth working an extra 10 years to 65 instead of retiring at 55 which likely would be an option? Maybe it would be, or maybe only 2 or 3 weekends would work and moving that retirement up half a decade could become an option.
Lets go over a couple specific examples to show how much of an effect any early savings can have on a persons long term finances:
*All examples are using historic stock market returns and factor in inflation (Rough a 7% annual return)
Person 1 & 2 received a $10,000 inheritance. Person 1 invested the money immediately and person 2 spent it on something extravagant. Person 1 wanted the same extravagant thing, but decided to save $1,000 a year for 10 years before they bought it. Person 2 also managed to save $1,000 a year for 10 years, but they invested it. After the 10 years both have the extravagant item and invested $10,000. How much money does each person have?
Person 1 who waited: $19,670
Person 2 who did not wait: $13,800.
In this case, the opportunity cost of purchasing the item 10 years early was just under $5,900. So while Person 2 may only have actually paid $10,000, they might as well have paid $15,900. If neither Person 1 or 2 touched those investments until they retired at 65, Person 1 would have $210,000 and Person 2 would have $148,000. By retirement time, spending $10,000 10 years early would have cost Person 2 around $60,000.
Person 1 and Person 2 are both 22, just graduated, and decided to plan for their retirement now that they have started working. Person 1 wants to try to be responsible and invest $150 a month for about 10 years until they have kids. After they have kids they plan on stopping the $150 and using that money on the kids instead. Person 2 believes your 20’s are about having fun and doesn’t want to start saving anytime soon. After that, they too plan to have kids and they also want the extra money to spend on their kids. After their kids are a little bit older, person 2 believes they will be able to start saving for retirement at around age 45.
Person 1, saving $150 a month for 10 years and then stopping will have roughly $199,000. Person 2 will need to invest over $630 a month for 15 years from age 45-60 in order to catch Person 1. Person 1 will have had invested a total of $18,000 (money they earned on their own, not compound interest), Person 2 will have had to invest $113,400. In examples like this, it is easy to see just how important any amount of early savings can help.