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February, 2008


Imagine if, shortly after children's births, parents, aunts, or uncles could give to each toddler a big bucket of coal or (even better) graphite mixed with a few other dross materials, oxides of manganese, nickel, or iron, perhaps, and, toward the end of their lives the recipients could cash them in (hopefully before they each kick the bucket!) and find then that the buckets were now each about one-third full of precious diamonds worth hundreds or thousands of times as much.

"Yeah. Right!" Midas and Superman aside, such a conversion hardly seems plausible.

Alchemists through the ages have attempted to make various relatively gross materials into something precious, copper or other base metals into gold for instance, but usually with either quite limited results or complete failures. And yet we know that in nature, and now even in the lab, large amounts of heat and pressure do indeed convert things of much lower price into substances of much greater value. It turns out that, under the right conditions, a bucketful of such seeming dross can become a rather substantial pile of precious diamonds.

And, particularly for young people, much the same kind of transformation is not just possible but almost assured, through good habits of saving and investing combined with the power of compounding.

What is the magic or power of compounding? This simply refers to an investment that is left to keep appreciating in value (rather than being cashed in or having its dividends or capital gains sent to the investor), so that, for example, an asset that goes up 10% a year, left fully invested, is then worth 110% of the original amount at the end of the first year, all 110% of which is receiving 10% through the second year, etc. Thus over time a higher and higher percentage of the original investment is appreciating.

In this example, it would take about 7 years for the compounded appreciation to double one's investment, whereas with simple interest, 10% sent to the investor as a dividend each year for example, a decade would be required to get back the original investment amount or have twice as much.

If a person begins tax-deferred investing early, or if one's parents or aunts or uncles, etc., have done it for her or him, as in the above bucket illustration the magic of compounding results can be staggering.

$1000 in a tax-deferred account begun on a child's one-year birthday, left in place (or converted to other later fully invested tax-deferred accounts), and appreciating on average at 10% a year, becomes, by the time she or he is 61, $304,482, a greater than 3000% increase.

So, if one wants a child in the U.S. to eventually be a millionaire by the time she or he turns 62, when reduced Social Security benefits may begin, one might need "only" invest $3284 in a tax-deferred account in the child's name (by the 2nd birthday) in an asset or assets likely to appreciate 10% or better in the average year and convince the recipient, the only really hard part, to leave the account fully invested till retirement.

It may be argued that the reasonable assurance of a 10% or greater compound average return is a hard part as well, but there are ways (such as sticking with low debt value investments in dividend paying companies) of greatly increasing the odds of this occurring over the long-term.

Nor should somewhat older persons just starting out as investors (as I did) be discouraged because they missed the full extent of compounding power by not having a tax-deferred gift early on from a rich aunt (or whomever) or not having the means or insight on their own to begin when still quite young.

The average household income in this country is now a little over $40,000. It is higher among college grads. But even assuming one were at that average level, a fairly modest portion of the initial total, say 10%, set aside annually and tax deferred in an Individual Retirement Account (IRA) or company 401k Plan can make a real difference.

For instance, if a young adult averaged setting aside only $10 a day ($3655 a year) and averaged only a 5% compounded annual return on the investment, in 50 years that nest egg by itself would grow to $791,335. But picture the result if the investments grew tax-deferred at a 10% average and if one contributed 10% of an increasing annual salary (the final nest egg virtually assured to be over $5,000,000)!

If a fully employed married couple start investing early, say at age 28, put a good chunk, say around $13,000 a year, of their paychecks into tax-deferred growth and income equity IRA and/or 401k Plan accounts, leave them fully invested, and if they get a 10% or better average return, they would have well over $2,000,000 in 30 years, and likely by age 58 would be able to decide how they want to pursue life more on their own terms.

Two or three other points might be mentioned. Just a single percentage difference in total annual compound return can be very significant in the final result. In the just above example, if the couple received 9% instead of 10% a year on average, the final total would have been nearly a million dollars less! So, just as starting earlier rather than later is significant, commissions and fees really matter, and picking good funds or strategies can be quite important as well. Starting late, picking a high fee mutual fund, or choosing or keeping one with a mediocre return can cost one dearly (and sadly all of these factors are often at play for the typical investor). Another big factor is taxation. After tax returns are a far smaller, less impressive source of nest egg growth than what is possible tax-deferred. Especially for young persons, it seems wise to put all one can into tax-deferred accounts, and Roth IRAs makes particularly good sense as, after people's net funds are invested through them, eventual distributions of appreciated assets will be tax free forever.

The concepts and monetary vehicles involved in successful personal finance are not nuclear physics. Though many investors do not manage their dollars or debt all that well, with less study and investigation than is usually spent selecting and buying a house, individuals or couples can develop highly profitable long-term investment plans, let the magic of compound investing work for them, and be on the road to financial security.

In less time than it may seem at first, our "buckets" one day can be sufficiently resplendent with the equivalent of diamonds, and we might then get on with finding what pearls in life are truly of great price.


Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)

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