I imagine you know the work of noted financial author Susie Orman. She’s all over the place and presumably she’s helped many Americans save more and make wise decisions with their money. Any sort of financial literacy is generally a good thing, but I find that some of the many National personalities out there aren’t always accurate with their guidance.
Case in point is something recently posted to Yahoo Finance.
“Orman said at Miami's eMerge conference in June: "You invest money and your money makes money, and the money you made with the money that you had makes money, and everything compounds." Orman explained that if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement. But if that same person waits 10 years to start investing, they'll end up with only $300,000. Waiting means blowing hundreds of thousands of dollars that could be made by simply letting your money sit and accumulate interest.”
I’ve broken this comment apart for clarification and we can look at each comment separately.
"You invest money and your money makes money, and the money you made with the money that you had makes money, and everything compounds."
This is true! Compounding is a real thing, but, unfortunately, widely misunderstood.
For years, investors have been told a myth of sorts. That if they leave their money invested in the market, compounding will work its magic. Unfortunately, the experts left out part of the equation. Compounding, a concept largely derived from how cash sitting in a bank grows, does not work the same way once you begin to take on more risk.
Per my friends at www.realinvestmentadvice.com
“This commentary is a bit “iffy,” as compounding only works when there is NO CHANCE of principal loss. It’s a linear wealth-building perspective that no longer has the same effectiveness considering two devastating stock market collapses which inflicted long-term damage on household wealth.”
Lesson: Not everything compounds.
So, yes, if your money is invested very conservatively, in a CD or similar, money will compound but that’s not what Susie is referring to - as evidenced by her second point.
“if a 25-year-old puts $100 into a Roth IRA each month, they could have $1 million by retirement”
Whoa! This is the part that gets my blood boiling. Let’s look at the math. If a 25-year-old were to make this regular contribution - $100 per month for 480 months (40 years), for there to be 1 million dollars at the end…wait for it…wait for it…
…The compound rate of return would have to equal approximately 11.50%. The assumption here is that the money would simply grow in a linear fashion year after year, month after month at 11.50%. I’d like to know where to put my money if that’s the case!
Virtually impossible. If it were that easy, everybody would be rich. If you run the same calculation at 6% per year compounded, there would be half as much at retirement.
Yes, put money in a Roth every month. That’s good advice. But let’s talk about expectations. That 25-year-old is going to have a nasty surprise in 40 years. A giant retirement shortfall. What you must know is that it’s virtually impossible to make up for a retirement shortfall by earning higher rates of return – which just causes you to face more risk. That’s not typically a good thing.
Susie’s final comment is correct.
“But if that same person waits 10 years to start investing, they'll end up with only $300,000. Waiting means blowing hundreds of thousands of dollars that could be made by simply letting your money sit and accumulate interest.”
This is sound advice though I’m not sure about her math. The sooner you start the better. Starting to save earlier, and saving more each month, each year are excellent strategies.
That’s just the way it works!