There is a story about Warren Buffett finding a penny on an elevator. He was riding the elevator up to his office with several executives. On the floor was a shiny penny, but no one seemed to take notice. But, when Buffett reached his floor, and the elevator doors opened, he reached down to pick up the penny, which amused the executives.
As he exited the elevator, without turning around, he held the penny up over his shoulder and said, “The beginning of the next billion.”
Here is one of the wealthiest people in the world demonstrating how he sees the potential value of money. If anyone else picked up the penny, the executives would be joking about it around the water cooler. But it was Warren Buffet, someone who truly understands what money can become.
The Most Powerful Force in the Universe
Buffett clearly understands the concept of money and time combining to compound interest over time — a phenomenon Albert Einstein once called, “the most powerful force in the universe.” The idea of deferring the use of money today to have greater quantities to spend later is the nature of investing, and most people hear about the magic of compounding at some point in their lives. But relatively few people grasp its magnitude.
Can compounding turn a penny into a billion dollars? With enough time, maybe. Consider the choice between receiving $10,000 each day for a month or a single penny that doubled in value each day for a month. Which would you choose? You would feel silly when you find out that, at the end of the month, your $10,000 daily gift amounted to $300,000, while the single penny alternative would have produced around $5 million. Such is the magic of compounding.
Explaining the Law of Financial Physics
When combined with time and interest, the growth of money can defy the laws of physics – financial physics anyway. Here’s a way to understand how time provides the leverage to multiply money growth exponentially, making it easier to achieve your financial goals.
Imagine a long plank sitting on top of a fulcrum – like a seesaw. You know that if you sat on one end of the plank and a person of equal weight sat on the other end, both of you would be able to move the plank up and down with relative ease. If you move the fulcrum further away from you, you have more leverage and can move the plank up and down with less effort. Conversely, if you move the fulcrum closer to you, you have to apply more energy to move the plank. If the fulcrum is too close to you, it may be impossible to move the plank. That’s how leverage works in actual physics.
The same law of physics applies in finances, but the fulcrum is time, and the plank represents how hard you have to work to accumulate money for retirement. The longer your time horizon (with the fulcrum set closer to the other end of the plank), the less you have to do to make your money work for you. The shorter your time horizon (with the fulcrum set closer to you), the more you need to do to make your money work. With a shorter horizon, you may need to invest more money and take more risk to earn the return you need, while a longer horizon allows you to invest less and take less risk because your money has more time to work.
Which Side of the Fulcrum are You On?
The obvious lesson here is you would come out much further ahead if you save early and often. But, when asked why they don’t start saving early, many younger people say they can’t afford it. That, they will just save more later in life when they are making more money. Sounds good, but it doesn’t happen like that. The biggest mistake younger people make is not to understand that time is their most valuable asset. It’s also a wasting asset. The more time you have, the greater your potential for accumulating wealth. The less time you have, the more it will cost you to achieve your financial goals.
Here’s how that might look in real life. Two people, both age 25, start their careers earning about $30,000. Karen begins to contribute 10% of her salary to a 401(k) plan. If she receives an annual salary increase of 2% and earns an average of 6% on her investments each year, she would have more than $620,000 by age 65.
(By forming her savings habit early, it’s highly likely that Karen would increase her contribution level over time making it possible to accumulate substantially more assets by age 65.)
Her colleague, Bryan, chooses to postpone saving for five years. Assuming the same level of contributions, earnings increases, and investment return, he would have less than $480,000 at age 65. If he were to wait until age 35 to start saving (as many younger people do), he would have $250,000 less. He can try to catch up to Karen, but it would require much larger monthly contributions or taking much more risk, which could be even more costly.
Be Penny Wise by Paying Yourself First
The lesson here is, if you think you can’t afford to start saving now, you may not be able to afford the much higher cost of waiting. In reality, anyone can develop the habit of saving early on – it just requires some discipline to adhere to a very simple rule: Pay yourself first.
Paying yourself first is easy when you participate in a 401(k) plan. And, if your employer provides a matching contribution, your contributions are magnified. However, if you don’t have access to an employer-provided plan, you can open an Individual Retirement Account and transfer funds from your checking account each month. The idea of paying yourself first is to make that transfer before making any purchases or paying any of your bills. If you are over budget in any month, the idea is to adjust your other expenditures before you change your monthly investment amount.
Another reason people put off saving is they don’t have any purpose for their money. Without a purpose or a life ambition, the extra money people have typically goes toward the pursuit of more, and more never provides contentment. Any goal is achievable when you make use of your most valuable asset – time.
