Leverage the 8th Wonder of the World For Your Own Benefit
Famed physicist Albert Einstein once said:
Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it.
Einstein is right. Storing your money in assets that increase in value is key to building wealth. If you consider long-term investing benefits, each year’s returns build off those of prior years and continue to grow.
- Invest $2000 in the stock market upfront
- Contribute $500 each month for 40 years
- Earn an average annual real return of 8% for 40 years
Your returns will look like…
By contributing $242,000 over 40 years, you can end up with $949,000, $1,597,800, or $2,746,000 depending on your average returns. You achieve a 4x, 7x, or 11x return on your money.
Even with the most conservative scenario, you are coming out ahead almost a millionaire. In the above example, I assumed an investment in the S&P 500 – the most commonly used benchmark for the stock market’s performance.
Real Stock Market Returns
With real average annual returns of 8%, investing in the S&P 500 will 7x your money over 40 years — netting a return of $1,597,000. This is the most likely scenario – putting you ahead of millionaire status!
The key to success as a long-term investor is to adopt a mindset of delayed gratification. Legendary investor Warren Buffet once said, “The stock market is a device for transferring money from the impatient to the patient.”
How I Got Started Investing
With my parents’ encouragement, I started investing early on in my teen years. Using an online brokerage, I had the ability to buy, sell, or research any stock I thought of. Once I started working, I enthusiastically taught myself the personal finance basics. Over that time, I saw the exponential growth effects of compound interest at work and realized that I would build wealth through investing in the stock market. The mathematics of investing drove my passion. I realized the benefits of investing in a person’s life and how it opens up a world of opportunity for one’s future.
Through my journey, I learned I did not have to be a professional to do well but rather to set investment goals realistically, be analytical, consistent, and patient. I also picked up a few life lessons and realizations from my experiences which I’ve jotted down below.
5 Benefits of Investing
1. Save On Taxes
Under current tax law, you are taxed more on your income from earned income than your investment income. The tax code incentivizes investments because injecting capital into a business can create jobs, and owning real estate provides a place for someone to live – all of which benefit society.
You earn investment income from interest on savings, dividends, capital gains, and rent. This income is exempt from Social Security tax and is taxed at lower rates than earned income. If you hold an asset for more than a year, you qualify for long-term capital gains taxes, which are taxed at a lower rate.
If you buy and sell a stock within a year, then you pay short-term capital gains at the highest rate in your tax bracket. For example, if you make more than $100,000 and live in CA, you would pay up to 33% on the profit you make from a stock sale!
I usually invest in stocks for the long term to simplify my tax situation, lower my tax bill, and grow my returns. The only thing most stock market day traders achieve is ending up in the red, partly due to high tax bills.
2. Home Buying
The staple of the American Dream is homeownership. Investing your money for even a few years can be a boon to help pay for a home. You can use some of your invested funds to pay for your down payment. A larger down payment reduces the size of your mortgage and lowers interest payments–helping you pay it off faster and cheaper.
Younger generations are delaying homeownership for lifestyle and career reasons. Most people prefer to buy a home when they are in a more stable place in life with a relationship or stable career prospects. The Millennial and Gen Z generations are infamously known for delaying life milestones which affect their home-buying decision-making.
If this is your situation, you can play it to your advantage by factoring it into your financial planning process. You can plan what a possible downpayment would look like and start investing. You could target less risky assets, so you have a larger reserve of wealth to tap when you decide to buy a home.
I plan to buy a home in the next 5 to 7 years, and I’ve made it a long-term financial goal to save for the downpayment. I’ve already started to invest in owning a home in CA, and with a long time horizon, I have plenty of time to build funds for a downpayment. Wish me luck!
3. Save for Retirement
If there ever was a reason to invest, it’s this one. Investments are your primary tools to build your retirement savings. With a time horizon of 3o to 40 years, your risk reduces exponentially, and the certainty of return increases.
Forget about 40 years, even holding for 10 years sets your expectation of positive returns at 93%! If you hold for 30 to 40 years, that expectation comes even closer to 100%. This trend implies that as market risk falls exponentially, over time it greatly diminishes the risk of negative returns.
Even if you have a shorter time horizon, you can balance out your portfolio with long-term holdings.
Society encourages you to prepare for retirement by offering special accounts such as the 401(k) and Roth IRA. Each has its own set of advantages and disadvantages.
- 401k — a pretax-advantaged retirement account where you can contribute up to $19,500 in pretax income each year. Contributing today decreases your current taxable income, but your withdrawals (and the growth on them) will be taxed in the future. You can start taking withdrawals at 59 ½ years old though the government can change that age when they want. An employer usually offers a matching option. If you contribute to the limit, then the employer will match your contributions at their predefined rate. Standard financial advice is to contribute enough to maximize the employer match.
- However, some people recommend prioritizing your 401k contributions and making the $19.5K max contribution. We encourage everyone to think about their individual situations and realize these funds will be locked up for 30-40 years. You should still invest in a 401k to build your retirement funds, at least enough to earn the employer match. However, you’ll have major life financial decisions, such as buying a house or unexpected expenses that will happen in the shorter term. It pays to be mindful of how much of your paycheck you invest in your 401k and anticipate that you have enough funds for shorter-term needs. Personally, I invest just enough in my 401k to get my employer match. I use my remaining net pay for living expenses, savings, and individual investing accounts.
- While you can borrow against your 401k as a loan, it is best not to do this as you have to pay it back with additional interest.
- I encourage long-term investing and preparing for whatever life throws at you in the nearer term.
- Roth IRA — a tax-advantaged retirement account where you can contribute up to $6,000 / year on a post-tax basis. Your contributions do not affect taxable income, and your withdrawals (and growth!) are tax-free starting at age 59 ½ — who doesn’t like free money? A Roth IRA is a great vehicle to invest in for people who expect to need more money in retirement and currently make less than $139,000. This is hands-down my favorite investment account as it offers the greatest deal and is best suited for young and middle-class professionals. You can withdraw your contributions whenever you want (minus broker fees) and take 10% of your money out to buy your first home. Whatever you invest in, you can withdraw tax-free, making it the only vehicle where you get 100% of your returns. Using this account, it is easy to become a millionaire by investing in a market ETF such as VOO, IVV, or VTI, with only a few hundred dollars a month. Coupled with a conservative 401k, you can take more risk in this account to capture potentially higher returns. This account is a great asset to your retirement and overall investing strategy.
Every dollar saved today is $5 at the start of retirement. The only cost is that of not starting. Your future self will thank you!
4. Safety and Security Needs
Maslow’s Hierarchy of Needs, designed by Abraham Maslow, shows the sequence of a person’s needs starting with sustenance and security and culminating with self-actualization.
Where does investing fall on this hierarchy? It depends.
For some people, becoming a millionaire may be part of their life journey and path to self-actualization. Investing in the markets could help a person feel financially stable, which satisfies one’s safety needs. Others see becoming financially stable as an achievement and hallmark of becoming independent, satisfying their self-esteem needs.
No matter how you slice it, having a solid financial foundation is key to help you best live out this life and have control over your time.
5. Attain Financial Freedom!
This is what it all boils down to. Financial freedom is about having the freedom a select few have that entails living out your dream life and not working to survive. Attaining financial freedom comes from using a reliable process and behaviors that work for you over time.
Investing your money in the long term generates personal wealth. Earning money on your money accelerates in growth over time. Your salary increases over time but will level off at a point in your career. Investment monies grow exponentially, thriving off of your assets’ returns.
Wealth is useful to live your desired lifestyle, secure your future, and even leave something behind to the next generation.
To get started, you want to leverage the potential of regularly investing in assets. What is an asset?
It is something that produces a positive economic value or a return. Here are some examples of asset classes:
- Equity – share of ownership in a company (i.e., Amazon, Alibaba, or Apple)
- Bonds – a debt note or IOU that represents a loan made by an investor to a borrower (i.e., companies, governments)
- Real Estate – physical structures used for living or commercial purposes
Standard financial advice uses the 50-30-20 rule, which says you should spend 50% of your take-home pay on needs, 30% on wants, and 20% on savings. From a wealth-building perspective, this rule is terrible. It implies that you should spend 80% on current needs and wants first, then consider saving.
The reverse is true.
An investor should save for oneself first, using one’s paycheck to save things important to them and spend on bills and other necessary expenses.
The smart investor lives below their means and saves more than they spend. They track their income and expenses – saving and investing before spending money on their “wants.” For example, I save around 60-70% of my monthly pay, with the rest going to necessary expenses like food and fuel. I use the rest to fund my “wants” – online classes, dining out, and traveling.
My personal finance journey taught me to think long-term and prioritize my needs and big goals first. I’ve learned that backing my financial goals with meaningful intentions motivates me to live out the behaviors that will help me achieve them. Coupled with consistent behaviors, the personal intention is an advantage in following through on your financial goals. Your personal finance system reflects your unique goals, circumstances, and processes. To achieve financial freedom and thrive, build a personal finance system that makes the benefits of investing work for you.