The Power of Time and Compound Interest
KEY POINTS
Invest your time, instead of spending it
The power of compound interest is key to growing your net worth
Can a $120 pair of jeans really decrease your retirement plan by $535? …. Imagine the impact on retirement by eliminating $10,000 of frivolous spending … this can be life changing
Up until now you have been spending your most valued resource to learn, earn, and master your cash flows:
T – I – M - E
Yes, there is nothing as powerful as time. The beauty about your legacy plan is that the Grow phase allows time to work for you 24 hours a day, 7 days a week, 365 days a year. It does not get tired, lazy, or take a day off.
You are the Master of your Time. Are you ready to take control?
Where to begin?
We must realize time is only valuable if we carefully harness its power. Time will yield little benefit if left unto itself. Time requires a very deliberate approach if it is to be effective, efficient, and productive.
For example, you can spend infinite time in a relationship, but the time spent will yield little in return if it is not spent in a focused manner intentionally relating to each other.
Likewise, time will yield little for your legacy plan if you are not intentional in its use.
Step one – give profound thought as to what time must do on your behalf
Step two - equip time just as you would any other productive asset
“An ounce of prevention is worth a pound of cure”
Benjamin Franklin
Simple right?
Of course, there are many layers to this process. We will only touch on a few in this post.
Profound thought takes an inherent dedication. You cannot simply spend a few minutes on a legacy plan or a related financial plan and assume they will come to fruition. A half-hearted approach will doom such plans from the very beginning. You need to customize your plans and continually reassess them as we will discuss later in the Plateau phase.
Let’s discuss a common example of time working on your behalf.
Compound Interest
The power of compound interest is about as fundamental as it gets.
Essentially, it is the concept that over time interest will earn interest on interest: hence the term compound.
For example, if you invest $100,000 at 10% simple interest rate per annum, you will earn $10,000 interest after one year. In year two, your principle starts at $110,000 and will earn $11,000 interest based on the same 10% interest rate. All things being equal, your annual interest earned will increase exponentially over time.
It takes some serious discipline to save money and invest in such a way so that it compounds over time. We recommend reading How to Set Investment Goals and Leave an Enduring Legacy to gain a better understanding how these steps can fit into your overall investment plan.
Legacies demand more than the basics.
Let’s expand the concept of compound interest to include a real-world situation.
We will assume you have two investment vehicles available. One, a tax-free savings account with mandated contribution limits. Two, a fully taxable investment account without any contribution limits. We will further assume the taxable income inclusion rates are 100% for interest and 50% for capital gains and dividends.
How would you allocate your interest bearing and non-interest-bearing securities between your tax-free account and your taxable account if you have already reached the contribution limit on your tax-free account?
Your answer to this question is critical as taxation is one of the most devastating hurdles to mitigate when building an enduring legacy plan. The concept of taxation is more fully explained in our post Personal Tax 101 - A Beginner's Guide.
One option to consider would be to allocate, to the greatest extent possible, the securities that attract a higher taxable income inclusion rate to the tax-free savings account (bonds in this example) and allocate those that attract a lower taxable income inclusion rate to the fully taxable account (dividend producing stocks in this example).
We recommend obtaining professional advice from your investment advisor (How to Choose a Financial Advisor - A Definitive Guide) when making such decisions. The example above merely introduces the concept of the types of decision making required to ensure time is working to maximize your legacy plan.
This is a small, but critical example of equipping time to work effectively on your behalf.
Now, let’s take the opportunity to look at this from a different perspective.
When conceptualizing compound interest, we often picture graphs displaying our investment portfolio growing over time. This can be a great tool. A graph showing $10,000 growing to roughly $45,000 in 30 years while earning 5% interest is a powerful tool. However, it may not provide the right motivation. Afterall, some investors may become completely demoralized when considering the tall order of saving the initial $10,000 (or $50,000, $100,000, $500,000, etc.).
The dollar amount is relative. The application is universal.
This may be a great time to quote a common proverb:
“Take care of the pennies and the dollars will take care of themselves”
Unknown
Compound Interest in Action
What if we broke down saving $10,000 into hundreds of smaller steps?
Sounds crazy, but smaller steps are so much easier to accomplish. You will gain confidence with each step. Each step draws you further down your legacy path while becoming progressively easier.
A great first step is to divert some discretionary spending towards savings. Consider resisting the purchase of a $5.00 specialty coffee and replace it with a free cup of coffee from the office.
What difference is $5.00 going to make, you ask?
That $5.00 coffee translates into a roughly $22.00 blow to your legacy plan: based on the same 5% interest rate and 30-year time horizon utilized above. That is a very expensive cup of coffee.
Up the ante. Maybe you could forego purchasing a $120 pair of designer jeans. That just added another $535 to your legacy plan.
Wow, it is amazing how much financial horsepower you can harness when you combine discipline with a well laid out plan designed to leverage time to your advantage.
This brief introduction to time and compound interest is foundational to any legacy plan. We will drill into other concepts related to time in other posts. Your legacy extends beyond mere financial goals. It also incorporates your personal, relational, and family generational goals. We will endeavor to revisit T-I-M-E and how it is so intimately integrated throughout all aspects of your legacy plan.
Until then, start letting time work for you and your family.
Enjoy!!!
