Even if you're brand new to investing, you're likely already familiar with the idea that you need money to make money. For example, putting $1,000 in Real Estate Investment Trust (REIT) shares yielding 5%, like Store Capital (STOR), could earn you about $50 per year -- enough for a nice dinner for two at your local Italian restaurant, tax and tips included.
Not too bad.
But put $1,000,000 into that account, and it could spit out around $50,000 in dividends per year -- enough for you to retire and still cover all your living expenses for the entire year if you plan and budget carefully.
Image source: Getty Images.
If not money, how about time?
Though it's intuitive enough to see that large starting sums have an outsized impact on your earnings, the fact of the matter is that few investors have a spare million dollars lying around.
If you're on par with the median American and only have $5,000 in savings , your engine of wealth accumulation isn't going to be the capital you have on hand. It's simply too small a sum to generate the sort of interest that'll allow you to quit working and revel in financial freedom.
If that's the case, then what recourse do you have?
Play the long game to win
Luckily for you, there's another way to build wealth. Though it'll require your patience, it demands little more beyond that. There's no field you need to till or hard labor you need to perform -- you simply have to wait.
Of course, what we're talking about here is the dual power of time and compounding. Money saved and left alone for long periods of time can compound into sums that are orders of magnitude greater than the principal amount invested.
In fact, long periods of time and compounding are such robust drivers of wealth that they can even compensate for lower savings rates. The earlier you start saving and investing, the less you'll need to save overall -- and still come out ahead.
To illustrate this phenomenon, consider two investors, A and B. Both investors save for 40 years and achieve a compound annual growth rate (CAGR) of 7% over that time interval, which is roughly equivalent to the long-term inflation-adjusted CAGR of the S&P 500; you too can replicate these returns by buying a low-cost S&P 500 index fund, like State Street's SPDR S&P 500 ETF Trust (SPY -0.21%).
Investor A saves early, investing $1,000 a year for the first 10 years -- but then saves nothing at all for the subsequent 30 years. On the other hand, Investor B starts saving later. They contribute nothing for the first 10 years but then diligently save $1,000 a year for the following 30 years.
Overall, Investor A saves $10,000 between years 1–10, and Investor B saves a total of $30,000 between years 11–40 -- three times as much as Investor A saves throughout the 40-year time period.
Who comes out ahead?
Turns out, even though Investor B saves far more than Investor A, it's Investor A who ends up ahead. At the end of the 40 years, Investor A has about $112,530 -- a sizable $11,460 or about 11% more than Investor B's $101,070.
Image source: Author's calculations in Microsoft Excel.
The reason for this surprising result is that Investor A started saving earlier -- and thus their investments had a longer amount of time to grow and compound. And this effect only becomes more pronounced as the CAGR for the investment period increases. If both investors compounded at 10% instead of 7% for the same 40 years, Investor A would end up with about $305,910 -- about $124,970 or 69% more than Investor B's comparatively measly $180,950.
What this means for you
The lesson to learn from this phenomenon is simple -- saving is good, but saving early is great. Over the long run, time and compounding will account for the bulk of your returns. So, if you don't have a lot of spare change to stash away at the moment, no worries -- you can easily make up for it if you start saving early.
If you're young, this is obviously great news for you -- start cultivating good saving and investing habits now, and you have a pretty good chance of retiring as a millionaire in later life.
But if you're older, that doesn't mean you're doomed either. Now that you're in your peak earning years, try to save as much as you can to compensate for your shorter time horizon, or consider delaying your retirement by a few years. And if you have children or grandchildren, pay it forward and start saving early on their behalf. For far more than money, you will be giving them the remarkable gift of time -- and the tremendous opportunity to become wealthier than you could possibly imagine.
