Let the Compounding Commence!

Every year, families and friends celebrate students who are graduating from colleges and universities. Parents beam with pride at their children’s accomplishments and exhale in relief now that the tuition bills have finally stopped. It is a time when adults give a lot of advice, which is why I have one simple idea I want to pass along to this year’s graduating class that I hope you never forget. Parents, take note as well, because with college out of the way, you can get back to focusing on retirement.

Let the compounding begin!

In case you did not come across this idea in an econ class, let me explain compounding simply. It is the process by which the value of an investment increases over time as earnings or interest are reinvested. It is the snowball effect but with money. Here is an example.

If you are a US investor and lucky enough to have up to $35,000 left over in your 529 college savings plan, you can roll it over into a Roth IRA starting in 2024, provided the account has been open at least 15 years.(1)  If you do not touch that $35,000 for 50 years, and the market averages a 10% annualized return, which is close to its long-term historical average, then guess how much you’ll have? (2)

A. $1,584,074
B. $2,551,167
C. $4,108,680

The answer is C. Over $4.1 million!

If you were to start this in your mid-20s and invest that same initial amount for only 45 years, you would end up with B, or $2.6 million. That is great, but not as great as C.

If you do it for 40 years, you will end up with A, or $1.6 million. Also good, but, you know, not C.

Another benefit of compounding is that it can help you pursue financial goals along the way, like making a down payment on a home. But do not worry if you spent your whole college fund or took out student loans. Start with a little and get in the habit of adding when you can. As you can see from this snowballing, having a lot of time can help make up for not having a lot of money.

In addition to increasing the value of your investments, compounding can also be a valuable force in life. For example, you have made an investment in time and money over the last few years that may have an enormous effect on the rest of your life. How much money are we talking about? College graduates, on average, earn 84% more than those with a high school education, and that adds up to an extra $1.2 million over a lifetime. (3) Parents, I hope you are feeling a little better about your investment too.

But it is more than just money. When you get to be like me, someone who graduated from college more than 50 years ago, you see that you are the result of the compounding of your life’s decisions, both good and bad. It is hard to quantify exactly, but it is sure there. For example, in graduate school, I decided I did not want to be a professor. That one decision continues to have a profound impact on the rest of my life. Instead, I started a company with the people I met in graduate school. Four decades later, I am still working with some of them. I even got to go watch my former professor and current colleague Eugene Fama receive a Nobel Prize in Economic Sciences. That was not on my bingo card when I graduated from college. Life is full of surprises, and many of them can come from how your decisions compound over decades.

So, start rolling your snowball, both in life and in investing. Let the compounding commence!