Comments due by April 18, 2015
“Compound interest is the eighth wonder of the world. He who understands it, earns it ... he who doesn't ... pays it.”
- Albert Einstein
Yesterday, in my Principles of Food and Resource Economics class (135 students--mostly freshmanpeople and sophomores), I was talking about cost-benefit analysis. In particular, I was talking about comparing benefits and costs across time, which of course leads to a discussion of discounting. Rather than drone on about discount rates and present and future values, I decided to show the class the power of compound interest--if nothing else to provide them with something useful they might use outside of class (it's not like they will remember any actual material from class).
So here is the example I used: Suppose, starting at age 25, you invest $1,000 per year at 10% return per year (the rough long-term average of the S&P 500) until age 65. Alternatively, suppose you waited until age 45, but invested $2,000 per year for 20 years. In both cases you are investing $40,000. Which savings plan would you choose?
Most of the class chose the delay option (probably because we had already spent a good amount of time talking about the time value of money). I then showed them how to calculate the future value of an annuity (FV=$X(((1+r)^n)-1)/r).
In the first case, the future value of $1,000 ($X=$1000) invested at 10% annual interest (r=0.10) for 40 years (n=40) is $442,593. This seemed to shock most of the students. Investing $40,000 could multiply by over a factor of 10. I explained that is the power of compound interest.
To emphasize the point I then showed them that the future value of the second savings stream ($2,000 per year at 10% for 20 years) is 'only' $114,550. Again, this seemed to surprise many of the students.
So I asked the class, "What is the most sure way for you to become a millionaire by age 65?"
Someone shouted, "Marry rich!"
(John Whitehead)
14 comments:
While I don't understand the math in this blog post, I do understand the general economic point. I had heard this story before, about how it is better to invest less over a longer period of time when you are younger than to invest more money for less time when you are older. This is an important bit of information to know, particularly for people our age (since this is apparently the prime time to start saving and investing)and I think because of this, it is becoming more common knowledge to save less sooner.
While this was a quick and interesting read, I'm not too sure how to relate it with the environment. It's possible that this post was just for the economics aspect of our class, but I'm wondering if there is something more that I'm supposed to be picking up on. Perhaps the point is that it's wiser to make small but continuous steps towards bettering our natural world now, as opposed to waiting for the future. This reminds me of one debate over climate change, which is that that we should start re-mediating now instead of waiting until we are out of fossil fuels and our world maps need to be completely re-written before we show concern over melting ice caps.
This is something I think about quite a lot, as I'm graduating in May and applying for jobs. I want to provide myself with security for the future, and it seems that investing small amounts of money now is the smarter choice, rather than investing more as I age. However, I find it interesting that most people, including myself, hold off on this expenditure. Why is it that we inherently think waiting, and investing more later, will make us richer? From a cost/benefit perspective, it seems obvious that investing small amounts now is much more feasible then giving out large lump sums later in life. Yet, this passage proved that most of the class thought waiting would provide the larger outcome. I myself seem to hold back on making investments for fear that I'm doing it wrong. Learning more about compound interest in college would allow for students to make these kinds of decisions that could ultimately benefit them in the future.
"The history of mankind is a history of repeated injuries and usurpation's on the part of man toward women…He had denied her the facilities of a thorough education, all colleges being closed against her." - Seneca Falls Convention, 1848
Home economics. We’ve all heard of it; cooking, cleaning, knitting, and child care. This is what Ellen Swallow Richards, the first American woman to obtain a degree in chemistry advocated for in the late 19th century. In the past hundred years, there has been a clear shift in the education obtained by women on economics.
No longer do women have to conform to the forced anti-feminist courses in home economics, but now there are opportunities. These opportunities allow for women to play a larger role in society and decision making in the household. Whether they want to make investments or spend their money frivolously, women have the option to choose.
Men as well have experienced a shift in society. The expectation to provide for a family is still fundamentally strong, but there has been many cases where men are supported by their wives and have claimed responsibility for the household. These men however, are targeted as wusses and weak.
As academics and school instruction has shifted from home economics to classic economics, the responsibility of finances must fall on someone. Whether it be the man or the woman, a person must claim responsibility for the house chores, including the finances. In Professor John Whitehead’s example from class, he questions his students and encourages them to think critically and rationally, choosing the most profit generating option. When posing the question, “What is the most sure way for you to become a millionaire by age 65?” it is not a surprise that students will answer to “Marry rich”. Although there has been a shift in the way we teach economics, some traditions may be so deeply rooted, that a student may consider this to be a viable option.
Due to a rising demand for supplies and the growing costs of certain goods, some individuals opt to grow rich and rely on materialism to fulfill their human needs and wants, but it is in fact the quite opposite. As explained in the IPAT model, the higher the affluence, the greater the environmental impact. As people continue to grow rich and rely on materialism to make them happy, the globe develops new and greater challenge, as a direct result of the goods produced and products demanded by the wealthy. To solve environmental degradation, and implement a sustainable society, there must be a steady state economic system, one which takes into account the externalities and impacts of every purchase.
It has taken over 150 years for Americans to switch from home economics to classic economics, hopefully it will not take as long to switch to a system of steady state economics. We just do not have the time to wait any longer. There must be a change in the economic system to solve and alleviate many of the issues we are burdening onto all future generations.
That last comment kind of got to me: "marry rich." Some people these days believe that if they marry rich, they can be rich. But you aren't as rich as your bank really tells you. As for the first example investing $1,000 every year until 65, I believe that this way you will feel richer than you actually are or will become. In the end you'll have more money then if you waited and invested double that, but the feeling that you would get after investing that $1,000 will make you feel rich for the future, rich at the moment you hand the grand over, and richer at heart because you are doing well in your life to put aside $1,000 for the future. Marrying rich is something that people tend to say just to be able to spend all the money they have now. "oh I don't have to worry about that; I plan to marry rich." Any time I hear someone say that, all I can do is roll my eyes and hold back the discuss and disappointment that I am feeling. If you want to be rich, then do something that will make you feel rich. If you want to retire with a bunch of money and relax the rest of your life taking care of your children, grandchildren, and so on, then set some money aside for the future AS SOON AS POSSIBLE. I am not saying right this second, but as soon as you have a stable job and a somewhat stable life. If none if this concerns you, goodluck marrying someone rich who will make you feel rich in your pocket and rich at heart every day.
In my opinion, this is an effective way to tech compound interest. I agree with Einstein that in order to make money through interest someone else has to pay. The example John Whitehead made in his class is effective at catching the attention as everyone focuses on money. Through example Whitehead was able to show (through math) that investing $40,000 at $1,000 a year for 40 years at a 10% interest rate will end up being a much higher number then the actual capital invested ($442,593). This seems like a large number, but due to inflation the amount might not seem as large in the future. Although this being said, it will be worth doing in the long run; although it will only be worth doing if there is no use for the money in the present. The reason why the number is so large is that interest builds up on past interest giving the person money that someone else pays. Overall, this is a great way to explain interest, but makes me wonder if this is the most effective system for our society?
-Frazer Winsted
This post is exactly what my parents have been saying to me for years. It's better to start saving money and gathering the interest earned earlier rather than later. This can apply to to what we have been learning in class when discussing the principle of sustainability. One way to not violate this principle is to save money or the rent and invest it for future generations. In this way, the present would not be favored over the future. Delaying any action will only hurt us and our future in the end.
-Emma Weis
As one reader noted earlier im not sure how this relates to the environment to i cant really comment there. But economically speaking i think more people need to learn about compound interest when they are younger (college years) because that is when you can really start saving for later on in live. Most people dont know anything about investing their money at this age, i know i dont know very much, and i think it would really benefit society if these younger people knew what they were doing.
Nick Stanton
Einstein summed up the magical properties of the compounding interest rates perfectly. I will outline an example to show the effects of a compounding interest rate. If you put $5,000 in cash under a mattress every year, it will take you 200 years to reach one million dollars. However, if you add a compounding interest rate to this example, the difference is astounding. The stock market has historical rates of return of about 11% to 12%. If we adjust for inflation, we can assume an approximate rate of return of 8%. So, if we instead invested $5,000 every year in an account that invests in a market index that will return approximately 8%, it will take us a mere 37 years to reach one million dollars. Well, here’s another crazy statistic. The one million dollars under the mattress in 200 years is worth only $0.21 today if use the same 8% compounding interest rate. Taking the awesome power of an compound interest rate, I can see why environmentalists do not like it. Because the compound rate or discount rate can exponentially increase or decrease a future amount. Therefore, as we have learned with the two period model when we applied a discount rate to the second period we have found that we are worse off in the future than the present. Thus, the discount rate helps to violate the pareto optimality.
As a Finance major, I believe that this is a great synopsis of the concept of compound interest. As we all know, a dollar today is worth more value than a dollar tomorrow. For obvious reasons that one can invest that money and earn a higher return at a later date. Other factors may include inflation. A prime example of this is what people do with the money that people earn immediately upon entering the work force. For those attempting to create wealth, many will have their asset's invested in a 401K or Pension Plan. For personal investing, many might consider investing in Equity Markets, Bond Fund's, REIT's (Real Estate Investment Trusts), Private Equity, Venture Capital, etc. All are based on the person's own risk and liquidity measures. Most people are not that well-versed in compound interest and lack the knowledge to make sound investment decisions.
Similar to my colleague's, I'm not entirely sure how this relates to our discussion of the environment but see how it makes sense in our discussion of economics. I'm glad to have read this article and gained more knowledge on compound interest and the cost/benefit analysis.
-Dylan Troy
As we swiftly move toward answers to address our climate epidemic, we constantly rehash time and time again the urgent need for a major shift in socio-economic values. In this process, we constantly fail to recognize that this would demand a major shift in the behaviors of all global citizens. Nonetheless, we have yet to falter in the excessive talk about becoming “millionaires”, or, one who spends money to consume and produce waste, further damaging our environment and our climate. If we were as dedicated to actually addressing our environmental issues as we are in striking it rich by age 65, maybe we’d actually get somewhere. We simply cannot state that we want and need answers for a better environment then, in the same breath, discuss the myriad of ways we all expect to equally become millionaires. If most did become millionaires in their lifetime, we’d see the very same disparity we do today, where there is a “taking from the poor to give to pete”. It is absolutely unsustainable and counterintuitive to environmentalism. Much more discourse and emphasis needs to be placed on voluntary simplicity, calling for reduced consumption and increased self-sufficiency. In evading conspicuous consumption, simple living includes being less traveled rather than well-traveled, growing one’s own food, composting food waste, earning a modest income, driving the most modest car, or rather, no car at all, wearing and donating second hand clothing and other material, eating locally etc. In forging a much deeper connection to our world, we see that wealth can never be measured in riches but rather in the health of the mind, body and quality of our environment.
I think this is very interesting bit of information, not even having to do with the Environment and discount rates into the future, but just for life in general. I feel like a lot of people are afraid to invest their money because they don't know how to do it and don't know how much money they will actually make. Investing for a longer period of time though makes sense. Though, as a college student, I'm still not sure as to what to invest when, but these are questions I'll figure out in time. As far as discount rates and the environment go, you can apply this same logic to resource use throughout time. As time goes on, the resources will be more valuable to us and will be worth more, especially because there will be less of them. We need to learn to invest in our resources rather than spend it all now, because there will be a greater turnaround asset in the long run.
Leanna Molnar
Many homeowners who have struggled to meet their
mortgages month after month, only to find after years of making payments that most of their money has gone to cover interest charges, have felt like cursing whoever came up with the concept of compound interest. In that element, around 1980 (when the neutron bomb and soaring interest rates were prominent news topics) Johnny Carson once quipped during a Tonight Show monologue that "Scientists have developed a powerful new weapon that destroys people but leaves buildings standing; it’s called the 17% interest rate." Perhaps that explains why many of us seem to recognize a kindred spirit in the declaration by one of the greatest intellects of our time, Albert Einstein, that compound interest is "the most powerful force in the universe" or "the greatest invention in human history." Since no context is ever offered for this purported quote, readers might also fairly assume that its intent was to praise compound interest as a wonderful device that allows thrifty savers to realize a significant, low-risk return on their money.
Reading it reminds me of all the times my family told me to save money. They’d tell me that now, since I’m young I should be putting away money. It’ll be easier now since I don’t have children and have less expenses. $1,000 a year for the next 40 years, at a compounded interest of 10% would only be 40,000 invested and a pay out of $442,000. This is a huge number over the initial investment. Another point is that now a days there are many student graduating with huge student debt. This is another reason why a lot of people are investing their money as they should.
-John D'Onghia
Compounding interest affects everyone the same, because it depends on time. If you ask any person older than you what they wish they had more of, chances are they will tell you they wish they had more time. Time is truly a wonderful thing, and it’s something we all share in common. Compounding interest works its magic because of this. It is a universal truth. Compounding interest at its core is best served by conservative investing. Someone who chases speculative and very trendy stocks won’t see the power of compounding interest.
Derek Fields
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