This weeks contributing writer is Scott Forbes he writes the blog After Hours Denver and in his essay below he writes about the power of compound interest!
Please help me welcome Scott!
TWO CONCEPTS, ONE GOAL
There are two financial concepts that just about everyone can understand and has mastered at one level or another. Those concepts are:
- Earn money
- Spend money
We all need to earn money. We can earn a lot or a little, depending on what we do, for whom we do it, and when we do it. Originating and selling sub-prime mortgages for Quick Loan Funding six years ago could net you enough to line your cat’s litter box with $50 bills while enjoy nightly dinners at The Palm, shopping junkets to Rodeo Drive, and a different Ferrari for every day of the week. Doing that job today wouldn’t put enough money into your pocket for a package of Raman Noodles, a torn t-shirt, or a bus pass. The job no longer exists.
The economy changes, but our basic need to earn money so that we can spend on our needs and wants, doesn’t. Mastering the concepts of earning and spending money will not help you save or even stay out of debt. Many behavioral finance experts postulate that people are largely predisposed to spend whatever they earn. If $1,000 comes in per month, $1,000 will go out. If $100,000 comes in every month, that much will go out. And often more. Point being, everyone knows how to spend and earning just feeds that ability to different degrees.
If you really want to reach the goal of saving money and watching your savings grow, the two financial concepts you really need to know are:
- Opportunity costs
- Compound interest
A couple hours before I graduated from college in 1987 I purchased a bottle of Screaming Cranium champagne and hid it under my gown. The people with whom I’d be sitting at graduation all thought it would be great if the first “pop” came from our section. When I shot the cork up into the air I got one swig before my fellow graduates grabbed it and went on to cannonball the remains. I remember being happy about graduating, but upset that the last $12 I had to my name had gone toward a single gulp of champagne. Given its brand name, it’s probably good that I didn’t get a second.
What I gave up to get that champagne was more than just the $12 I’d had in my pocket, however. I’d given up the opportunity to let that $12 acquire something much more significant for me and for my future. If I had not turned that $12 over to a stinky liquor store clerk with bad breath in upstate New York—and instead used it to buy a couple shares of Procter & Gamble stock at $6/share—that money would be worth well more than $2,000 today.
The secret is compound interest—proclaimed by Albert Einstein as the “most powerful force in the universe.” In its simplest, easiest-to-understand form, compound interest is money that earns money. If you have a savings account you are taking advantage of the most powerful force in the universe, though in its least powerful form. No one gets rich via savings accounts, not even banks. If you have a balance on your Visa card that you roll over from month-to-month, you’re a victim of the most powerful force in the universe. You’re also funding a lot of corporate bonds and helping make other people rich with your money, but that’s another subject for another time.
Compound interest, as well as four stock splits and a present per-share price that’s hovering around $67, is what would make that $12 I spent on Screaming Cranium in 1987 worth so much more today.
Anna’s blog, as well as other sites, encourage people to save by foregoing little things like the daily $7 Mocha Thunderclap Triple Latté at the local designer coffee shop. Or brown-bagging a lunch instead of going out every day and spending $8 on burgers and fries. There’s a lot of wisdom in such advice, but it all goes for naught if you transfer that savings by turning it into spending money for the evening or the weekend.
Think about the opportunity costs of those cups of hot, brown water. If you save it you can soon have a nice stash of “rainy day” money in your account. If you invest in something that’s performed like P&G over the past 24 years, you can have a lot more. Come to think of it, Starbucks stock’s done pretty well…
Scott Forbes •THANK YOU• for being a part of And Then We Saved!
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