The New Commonsense Guide to Your 401(k): Rebuilding Your Portfolio From The Bottom up

Chapter 9. The Rule of 72

INVESTORS ARE ALWAYS looking for that one magic investment that will make their fortune. The closest thing you will get to magic in investing is the compounding of interest. What that means is that your earnings generate their own earnings so that, seemingly by magic, money begets more money and the money you invested doubles, triples, and quadruples. Albert Einstein is alleged to have called the compounding of interest the greatest mathematical discovery of all time.

When an inexperienced investor thinks about saving for a goal, he typically estimates how much he needs and divides it by the number of years—or months—that he has to meet his goal. So to save $10,000 in five years, he might figure he needed to stash away $2,000 a year. He's wrong.

Time is the magic ingredient here. The power of compounding means that even a tiny sum of money can grow into a colossus given enough time. Consider the $24 paid by the Dutch for the island of Manhattan in 1626. Had it been invested at 7 percent, it would have grown to 4.03 trillion by the end of 2008, assuming of course that it wasn't invested in the stock market in 2008.

Few of us have three or four centuries to wait for our money to grow. But some of us are young. And for the young, time is a beautiful asset. Let's assume a twenty-one-year-old wants to accumulate $1 million to retire at age sixty-five. Assuming that the money returns an average of 8 percent a year, this young worker would need to put away just $2587.25 ...