For a long time, a million dollars has had a sort of mysticism about it, like if you had a million dollars you’d be rich (heck, it’s even the lyrics to a song). However, a million dollars is actually easily within reach of the typical family. How? Through time and compounding.
The basic idea
The biggest financial rule that most people underestimate is the power of compounding. Compounding is the idea that, if you invest over the long term, you don’t simply make money of your initial investment. You also make it off the income that you earn on that investment.
For instance, if you invest $100 and make a 10% return, you’ll have $110 the next year. But that second year investing, you won’t simply have $100 to invest, you’ll have $110. And if you get another 10% return, you’ll have $121.
That might seem obvious, but what’s really happening here is exponential growth, and over time, exponential growth becomes huge. And people generally don’t have a good intuitive feel for just how much exponential growth explodes. For instance, if you kept investing this way, do you have a good feel for how much money you’d have in 60 years? Just guess….
$30,448. Without invest any other money, your $100 has become over $30k.
Now how about you don’t just start with $100, but start contributing more often?
Making the million
So instead, let’s suppose you have the median household income in the USA, $57,616, and you decide to save 10% of your income every year, getting a 10% return. After 60 years, you’ll end up with about $25.6 Million.
Now, there are a bunch of obvious flaws in this calculation, and they matter a lot because, when you do compounding calculations, seemingly minor changes to the rate of return or the timeframe have huge effects on the results.
So, the 60 year timeframe is pretty lousy. What’s the point in having $25 million when you’re 80 and you’re physically far less capable, not to mention only having a decade or two of life ahead of you? So, let’s cut this back to 40 years, so, if you start this game at 20 or 25 years old, we’re actually calculating your net worth at your retirement age.
And also let’s cut back the 10% to 7%. People do get 10% sometimes (some people like Warren Buffett have made 20%+ for decades), but pretty well anyone can make 7% in an index fund.
With those numbers, you break a million on year 38 and by year 40, you’ll have about $1.23 million.
The other factors to consider are taxes and inflation. Taxes aren’t that big a problem, since index funds tend to be very tax-efficient. Thus, taxes won’t subtract from your returns significantly.
Inflation, however, will. There’s no great way to deal with it, except saying that being a millionaire in 40 years will still be much better than being broke, even if being a millionaire won’t be what it is today. Plus, all these numbers assume that your income is fixed at today’s median income, when really, it’ll likely be growing at inflation or faster. So, you’ll be able to invest larger sums as the years go by, counteracting inflation slightly.
How to do it?
The other big problem with this approach is that nobody can save 10% of their income because everyone has bills to pay. My answer to this is that’s largely just an excuse. Do you really believe that nobody lives on a salary that’s 10% less than yours? If that’s true, you really aren’t making much money and should seriously look at upgrading your skills so you can get a better paying job.
In university in 1990, I lived on about $8,000-9,000 per year, about a quarter of which was university-related expenses like tuition and textbooks. After school, my salary jumped to $57,000 per year, and I ended up spending much of that because I had the money to spend. But I don’t think my lifestyle was significantly better than when I was at school, nor was I significantly happier because of that extra income. It’s just that money was there, so it was spent.
The way around the issue of your lifestyle expanding to take up all the income available is through a “pay yourself first” strategy. That is, have the money for investing automatically deducted from your paycheck before you receive it. If you’re making $2,000 per month, then deduct $200 for investment, and only have $1,800 actually reach your bank account. Live like that $1800 is your actual income and you’ll never miss the $200 that was deducted.
This strategy is the key to accumulating wealth for most people who aren’t entrepreneurs. It’s simple, reliable, and doesn’t significantly hurt your lifestyle. If you never see the money, you won’t be able to spend it. This was the exact strategy that I used initially.
The bottom line
Today, there is actually a reliable set of rules that you can put in place that will enable you to become a millionaire. It doesn’t take much effort or even much impulse control. All you really need is an afternoon or two to set up all the paycheck deductions, and then just wait. You’ll end up a millionaire.