The Magic of Compounding
The magic of compounding was evident when I recently compared my lifetime gross wage income to my current net worth.
“Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it”
— Attributed to Albert Einstein
Albert Einstein probably never referred to compound interest as the eighth wonder of the world, but this is such a good quote! Even if Einstein never uttered these words, the sentiment is certainly true.
Compound interest is merely one example of an exponential function. Human beings have great trouble thinking in exponential terms. It is far easier to think in linear terms and, because this is our natural instinct, most people vastly underestimate the power of investing over a long lifetime. Compounding takes a long period of time to work its magic and we live in a society that prizes instant gratification above all else.
I’ve written a great deal about personal finance over the past fifteen years, so I will not belabor the point. Most of my readers are already likely to be aware of the power of compounding and are capable of thinking in exponential terms. We have all seen the mind boggling graphs that show the effect of investing a lump sum and earning even modest returns over three or four decades. The same is true for dollar cost averaging over a long career. It does not take any heroic investing results to achieve tremendous results if we start early and consistently save and invest over time. Obviously, those mired in true poverty will find this prescription difficult, but this is no excuse for the vast middle class in a very rich country like the United States.
While I do not have much to add about the principle of compounding, I ran into an example of its power this morning and thought it would be interesting for readers. The Social Security Administration sends annual statements to workers who have paid into the system and I just received a report of all of my earnings through the end of 2023. This prompted me to add up my lifetime gross wages and compare it to my current net worth. I knew that the result would look favorable, but I never went through this process before.
The Social Security statement lists all wage and self-employment income subject to Social Security and Medicare taxes. While there is a cap on income subject to Social Security, there has been no cap on wages subject to the Medicare tax since 1993. As a result, I added up all of my lifetime gross wages subject to the Medicare tax. I then compared this figure to my current net worth.
My current net worth is 3.7x the total of all gross wages I have earned over my lifetime.
I find this figure quite remarkable for several reasons. My first wages were earned during the 1980s while I was a teenager with a paper route and after school jobs. I did not earn any substantial wages until 1996, the year after I graduated from college. I then earned solid, albeit unspectacular, wages for the next thirteen years. I retired from regular employment in 2009 and have hardly had any income subject to payroll taxes since then. About 98% of my lifetime wage income was earned between 1996 and 2009.
Throughout my wage earning years, I dramatically underspent my income and invested my savings. I’ve written about some of my early success as an investor, but it should be emphasized that I had no true “home runs” to speak of. My results were basically singles and doubles, with the occasional triple, but sustained over a very long period of time with few permanent losses. My lifetime record has also been enhanced by lucky profits earned on the sale of two homes in California, the first in 2000 and the second in 2002. In both cases, my intention was to live in the home for a long period of time, but relocation for work upended my plans. I benefited from the capital gain exclusion on home sales and reinvested the profits in securities.
Some writers are comfortable sharing specific figures, but I am too private of a person to do that, other than to say that I have certainly reached financial independence and have navigated very early retirement quite well. When I left my last job in 2009, it certainly did not feel like it was an advantageous time to do so. My net worth had been pummeled by the financial crisis and subsequent bear market. But I did not panic and the past fifteen years of returns in stocks have solidified my financial position beyond any question.
I suspect that most readers who have been working in finance for a long period of time would regard my net worth as respectable but nothing special. I will not be flying on NetJets anytime soon and a Manhattan penthouse with a view of Central Park is not in my future. The same mentality that achieved financial independence would preclude any irresponsible spending today. I cannot afford a NetJets share but I could afford to spend far more than the 1.5-2% of my liquid assets that I draw annually. However, doing so would not improve my life. This is not to say that life is perfect, or even satisfactory, but the problems that I have in my life are simply not ones that can be improved by spending more money. However, the fact is that all of my problems would be far worse if I had to trade my time for money and felt financially stressed.
Part of getting older is gaining insight into the reality that living a good life has far more to do with factors such as health and family that simply cannot be purchased with money. However, money is definitely a prerequisite for living a secure life. Since poverty almost always guarantees misery and since anyone in the middle class or higher can easily attain financial independence over a lifetime, there is no excuse to persist in irresponsible spending. Your future self will thank your present self for being prudent and sensible.
The point of writing this article is not to be self-congratulatory and pat myself on the back. I am proud of my accomplishments, but the reality is that they were very ordinary. I had a good job in the software industry and made good income, but anyone in finance would laugh at that income if I revealed it. I simply saved a large percentage of my earnings and invested it reasonably well. Anyone can do this. Nothing I accomplished is beyond the reach of anyone earning a decent income who has a reasonable amount of self-discipline.
Copyright, Disclosures, and Privacy Information
Nothing in this article constitutes investment advice and all content is subject to the copyright and disclaimer policy of The Rational Walk LLC. The Rational Walk is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com.