A few weeks ago I got a wonderful question from a reader. Essentially, the reader's daughter had earned a little bit of money at a job and this responsible dad was going to open up an IRA for his child with the earnings. That struck right at my heartstrings because I did something similar for my little one. And if history is any guide, both of our kids will be much better off because of it. Here's why you should consider doing the same thing...
The working life of a dollar
My first introduction to compounding came from a book my dad made me read called The Working Life of a Dollar. It was one of the few books in my life that I can honestly call transformational. It was a short and simple book that walked through how much a dollar would be worth over time if you didn't spend it. (I'll admit that, at the time, NOT spending money was a novel concept to me.)
Truth be told, the book looked at the same topic in so many different ways that it was a little boring. But it changed my life, and I'm hoping the life of my daughter, too. Here's why...
You see, if you save $1 and invest it, it grows. Yeah, you know that. But add in compounding and enough time and you start to get some pretty impressive numbers. For example, most people reading Seeking Alpha probably think in terms five, 10, 15, and 20 years. If you took a single dollar and compounded it at 10% (the rough historical return of the stock market), you'd have about $1.60 after five years, $2.60 after 10, nearly $4.20 after 15, and a touch over $6.70 over the full 20-year span.
Past returns aren't predictive of future results, of course, and averaging 10% recently hasn't been the norm. But, it shows the power of compounding. To figure out the impact on a larger sum, just multiply by the dollar figure you start with. For example, if you started with $1,000 invested for 20 years at 10% you'd end up with around $6,700.
But that's you and I. What about a child that's of working age? Lets assume this kid is 15. That child has 50 years before they'll retire. If you put a dollar away for your crazy 15 year old, who'd rather buy a video game or clothes than save money, it would turn into $117 or so by the time they were ready to retire compounded at 10%.
Don't believe me, set up an Excel work sheet and prove it to yourself. The math is simple. To figure out the first year you'll multiply 1 times 1.1. Then you'll take the result of that problem and multiply it by 1.1. And keep doing it until you've multiplied a total of 50 times. If you are into math, you can also do this in one cell with the formula: 1*1.1^50.
Can your child/grandchild afford you not doing this?
Even if you assume a lower return, which is completely reasonable, you still get amazing numbers over 50 years. For example, at a 7% return a dollar would turn into nearly $30 over 50 years. While that's not nearly as exciting as $117, it's still a huge number.
My hat goes off to this dad. He's pretty much helping to ensure that his child has a worthwhile retirement. And since it's "trapped" in an IRA, he's also ensuring that it will be hard to get at when his child realizes it's there. Truth be told, my dad did a similar thing for me. (Yeah, my dad is pretty smart when it comes to money... I can't even begin to explain how much I owe him for the knowledge and advice he's given me over the years.)
But what if you pull that 50 years out to say, 60? A dollar becomes over $300 if compounded at 10% over six decades. At 7% it turns into a still respectable $58 or so. What about 65 years? The answer is $490 at 10% and $81 at 7%. So, if you gave a child $1,000 a age five and put it into a mutual fund that earned 10% a year on average, it would grow to $300,000 by the time they reached 65. If you gave it to them at birth it would grow to $490,000. At 7% those figures would be $58,000 and $81,000, a lot less, but still worthwhile.
What I did
The question that this astute father had for me was what investment would I recommend. And on that I offered up Vanguard Balanced Index Fund (MUTF:VBINX). The fund is a 60/40 mix of the entire stock market and the entire bond market. It won't be the best performer, but it's simple and requires zero maintenance. After all, dad might not be around to manage his child's portfolio over the entire 50 year span. And his child may not want to bother. So, setting it on autopilot is the play it safe approach.
Now, I did this same math when my own daughter was born. And I decided she couldn't afford me not putting money away for her. But my newborn didn't have a job and I wanted to keep it out of reach until she was retirement age. So, I opened up a cheap, no-frills, plain-vanilla annuity with Vanguard. I put in enough to get the account open and set up a portfolio allocation I liked (VBINX wasn't an option) that would automatically rebalance the portfolio every year.
Over a few years I put more money in, but I haven't added funds in probably five years or so. My daughter has no idea, but she's got a modest chunk of change in her account. And the value of that account is 70% higher than what I put in despite the volatility seen in the broader markets since she was born. Now my daughter is still pretty young, with another 50 years or so to go before retirement. If the portfolio I set up averages 7% a year from here my little one will be retiring a multimillionaire.
Although the ravages of inflation over the next five decades will mean that being a millionaire won't be as exciting a thing as it would be today, at least I know that I've set my daughter on the right path. One that she may or may not have decided to take on her own. And if you take a moment to look at the power of compounding, you might just decide to set up something for your children and/or grandchildren, too. I highly recommend it!
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.