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By now all the frugal followers have begun amassing a tidy fortune from my money saving tips, but what should one do with these new found riches? The answer is where phase two of the Frugal Franco plan (save - invest - give back) comes into play.  Most everyone has heard the old adage, “it’s never too late to start saving,” but really it should read, “It’s never too early to start investing.”

First let’s address the timing issue. There definitely comes a time when it is too late to start saving. If you haven’t started saving by the time your grey hairs (or lack thereof) strongly outnumber their less grey brethren and AARP continues to pester you about membership benefits, you’re better off taking what you got left and “investing” in some lottery tickets (just kidding…the lottery is NOT an investment!). The average American saves somewhere between nada to 1/20th of their disposable income. This doesn’t leave much for retirement if you start late and don’t invest the savings.

Which brings us to the second point, saving money and stuffing it under the mattress isn’t an effective way to build a nest egg. Even at triple the average savings rate, it would still take several years of savings to cover a single year’s worth of living expenses. All the while, inflation would slowly erode the value of that hard earned mattress money. The key to fighting inflation and creating wealth is a simple, yet amazingly powerful tool — compounding.

Albert Einstein referred to compound interest as “the greatest mathematical discovery of all time.” The best way to explain this “discovery” is through an example. Assume we have $100 which is invested at a 5% annual rate of return. At the end of the first year, the investment will be worth $105 ($100 + $100 * 5%). The second year we make 5% interest on the full $105 rather than just the original $100 investment. At the end of the second year, the investment will be worth $110.25 ($105 + $105 * 5%). Now I know what you are thinking…what’s the big deal about an extra 25 cents? Not much at first, but this small added return is where the “magic” is born. After 10 years, the investment will be worth $162.89 vs. $150 without compounding. After 30 years, it will be worth $432.19 vs. $250 without compounding. And taken to the extreme, after 100 years the investment will be worth $13,150.13 vs. $600 without compounding. This is why Einstein also referred to compound interest as “the eighth wonder of the world.” 

Einstein is also credited with the “Rule of 72,” which is an easy way to approximate how many years it takes to double a sum of money. Simply take 72 and divide by the rate of return to figure out how many years it will take to double the original investment. For example, it will take just over 14 years to double an investment at our assumed 5% rate of return (72/5 = 14.4 years) and half that long (72/10 = 7.2 years) to double it at a 10% rate of return.

There is one more piece of the pie that we have not considered. Up to this point, we’ve only looked at future returns on an initial investment without considering any newly invested money over the time horizon. When new money is added into the equation, the compounded returns become even more pronounced. Using a compound interest calculator (or Excel and some handy dandy equations if you’re a nerd like me) we can figure out the return on a stream of investments over time. Let’s take a look two examples:

Frugal Francine always looks for a bargain, saves money by buying used, budgets her spending, and has started investing her savings early on in life. She has a good job making $40,000 a year which increases every year by 3% to keep up with inflation. She saves 10% of her gross income (the income before Uncle Sam gets his greedy little paws on it) every year and plans on working for the next 40 years before retiring. Because she is younger, she is able to take on more risk with her investments, which should produce a higher rate of return over her long time horizon. She invests all of her savings into some low cost exchange traded funds which track the performance of the global stock market with the goal of generating 10% -12% annual returns over time. As she gets older and closer to retirement she will begin shifting part of her investments out of the stock market and into low risk bonds at 5% - 7% interest. Because of this, she expects her average rate of return over the 40 year time period be between 9% - 11%.  Francine is also a smart cookie and knows that the value of a dollar 40 years from now won’t be worth as much as today’s dollars because of inflation, so she discounts her expected rate of return by 3%. Let’s see how she makes out (everything is expressed in today’s dollars to account for inflation):

• Total amount invested: $160,000 ($4,000 per year * 40 years)
• Value of the investments after 40 years: $620,000 - $1,030,000
• Total profit from investments: $460,000 - $870,000 
• Total rate of return: 290% - 540%

Lavish Larry, on the other hand, is not so frugal and enjoys spending money as fast, if not faster, than he can make it. He is also young and has a good job making $100,000 a year. Because of his extravagant lifestyle and high income, he has little concern or desire to save for retirement. About halfway through his career on his 40th birthday, he starts to think about the future (these things happen when you reach the top of “the hill”) and planning for retirement. He has become very successful in his career and makes $300,000 (inflation adjusted) annually. Unfortunately his balla lifestyle of buying fancy new cars, drinking Cristal, and renting a huge penthouse loft in the city have put him in debt to the tune of $200,000. He assumes that if he changes some of his spending habits he can start saving close to 20% of his salary to start paying of the debt and saving for the future. It’s a tough lifestyle shift and takes him 5 years to finally pay off the debt. He would like to retire when he turns 60 (15 years) and is advised to invest in a mix of mutual funds and low risk bonds because of his somewhat truncated investment horizon. He expects to make an average return of 7% - 9% annually on his portfolio before inflation (4% - 6% after inflation). Here’s how Larry pans out at retirement (again…in today’s dollars adjusted for inflation):

Larry may end up with a larger nest egg, but his captial outlay ($900k) was much larger as well. It will be much easier for Francine to retire on her nest egg because her living expenses are lower due to her frugal/value creating ways. Larry on the other hand is going to work a lot longer or save a lot more if he wants to sustain anything close to his current lifestyle after retiring. In conclusion, it’s not enough to just save. The secret to creating wealth is to save, invest the savings regularly, and maximize your time horizon and subsequent returns by starting early in life.

Ciao,
Franco

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