“If someone gave you $25,000 tomorrow, what would you do with the money?”
My friend and I were out to dinner, and enjoy these type of “what-if” questions. I expected him to say something like “Buy 25,000 lotto tickets,” or “Get a Giraffe,” or “Travel the world.”
His answer caught me off guard. “It’s funny you ask,” he said, “because yesterday I inherited $50,000.”
He explained that his grandparents had passed away a few years ago, and left him some inheritance money. His parents had been keeping the money for him in a savings account, and until yesterday, he had no idea it existed.
“Are you serious?” I said. “What will you do with the money?”
“Keep it in the savings account, I guess,” he said. “I probably won’t touch it till I retire.”
His answer was troubling, but didn’t surprise me. Many people believe savings accounts are the safest option for their money, because they think they can’t “lose” any money. The problem is, they tend forget about the corrosive power of inflation. The interest you earn in a savings account (.06% on average) isn’t enough to keep up with inflation (3.18% per year on average), meaning the value of your money erodes over time.
Being the personal finance nerd I am, I spent the next hour explaining to him why he should invest the money in a low-cost index fund instead.
Index funds, I explained, would allow him to invest in some of the best companies in the world. His money would be working for him, while he lives life as he pleases. By the time he retired, he would likely be rich. He liked the sound of this.
The Magic Of Compound Interest
We did the math. My friend is 27. He loves his job, and plans on working for the next 40 years. This table shows the hypothetical growth of his $50,000, if he parked his money in an index fund for 40 years, and never added another dime.
These calculations assume he puts the money in a taxable investment account, and is taxed at the 25% federal level.
The S&P 500 has averaged of 7% per year since 1950 (inflation adjusted, with dividends reinvested). If we use this as our benchmark, our best estimate is that my friend’s account balance will be around $387,127.64 in 40 years.
This means he can simply deposit his money today, not think about it for 40 years, and likely 6x his investment . Such is the power of compound interest.
On the other hand, if he left his money in the savings account at his local bank, he’d essentially earn -3% interest each year (when you adjust for inflation). After 40 years, his $50,000 would be worth around $15,328.
My friend sat across the table with a confused look on his face. “You’re telling me that if I put $50,000 into the stock market, and leave it there for 40 years, it would be worth around $400,000, and if I don’t it will be worth $15,000?” he said.
“Yes,” I replied.
I helped him invest the $50,000 a few days later. That single conversation likely saved my friend ~$372,000.
The question is, what are your savings costing you?
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