The Magic (or Curse) of Compound Interest and the 80-10-10 Principle

Making smart decisions about what to spend and how to save doesn’t sound like much fun to most people. They’re often lumped together with balancing the checkbook and choosing between complicated investment options on the list of things we don’t really understand and would rather not spend our time doing. So they’re often neglected. But it doesn’t have to be that complicated, according to someone who should know: Pledger Monk.

Pledger MonkPledger has spent a lifetime studying, managing, and teaching prudent finance and investment. He holds a bachelor’s degree in economics as well as an MBA from the Wharton School at the University of Pennsylvania and has spent the past twenty years as a financial adviser at one of the most prestigious investment banking firms in the world. So it should be no surprise that he’s well versed in the most modern and sophisticated financial theories and investment vehicles.

But what might be surprising is that when asked what are the most important concepts about money that people need to learn, he offers two deceptively simple ideas. And the first is one you think you understand. But you don’t.

Compound Interest

As Pledger explains, “I believe one of the most important concepts in investing and finance is one that’s not talked about enough. In fact, it’s supposedly well understood. Even finance professors in school assume all their students understand this principle like the back of their hand. But in my experience, they don’t. The concept is this: compound interest or exponential growth. Everything in our financial system works on a compound basis. If you understand it, it can work for you to your benefit with incredible force and power. If you don’t understand it, it can move you with equal force in the opposite direction.”

And most people simply do not understand the magnitude of that force. Pledger believes this is because we’re taught from an early age to understand mathematics in a linear fashion: two plus three, three times four, five minus one. “We can do those problems quickly off the top of our head,” he explains. “But if we’re asked to answer an exponential question, our minds just shut down. If I asked you what’s six to the fifth power, or three to the one-fourth power, most of us couldn’t even wager a guess. And if I asked what four is to the negative eighth power, you wouldn’t have a clue.”

How many pennies? 

So when Pledger teaches courses on investing at his local university, he introduces this topic with a couple of insightful examples. He first asks the class, “If I were to give you a penny every day in January, how much money would you have at the end of the month?” Just about everyone quickly answers “thirty-one cents.” “Correct,” he tells them. “Now what if I gave you one penny on the first day, but two pennies on the second day? Then I doubled it to four pennies on the third day, and doubled it again to eight pennies on the fourth day, and so on until the end of the month. Now how much money would you have?”

Cute boy with a stack of coinsMost of the guesses he gets are in the $10 to $20 range. “Sometimes I’ll get a few guesses around $100, and occasionally someone will throw out a really big number. But no matter how big it is, it’s never even close to being big enough.” And he can say that confidently, because the correct answer is 2.1 billion pennies. Yeah, that’s billion with a “b.” More than 21 million dollars’ worth of pennies. “You could all retire very nicely at the end of the month.”

Folding paper

Next, he asks them to consider a piece of paper. “Now fold it in half. Then fold it again, and again. Now imagine folding it forty-five times.” That last statement usually gets a good laugh, because most people realize you couldn’t actually fold a sheet of paper more than six or seven times since it would get too bulky. But he asks them to just humor him. “How thick would it be?” he asks.

“Just to get us in the ballpark, do you think it would be thicker than a good dictionary?” Some people think so. “Would it stack higher than this desk?” That turns out to be too thick for most guesses. “Higher than the ceiling?” And that’s usually where the rest of the class drops out. “The correct answer,” he tells them, “is that it would be thick enough to stack from here to the moon!” He’s right, and perhaps even much farther depending on what kind of paper you’re folding. If the 2.1 billion penny example didn’t work, this more visual example usually brings the lesson home. And that lesson is the uncommonsensical nature of exponential growth.

When his students are all sufficiently impressed with its power, that’s when he explains to them that every time they choose to buy something, or pay off a debt, or save and invest their money, they’re making an important decision. They’re choosing whether to let the power of compound growth work for them or against them. True, these examples are deliberately extreme to make a point. Nobody will pay you 100 percent interest compounded daily or extract that kind of penalty for a late payment on your mortgage. But the difference between investing money at an 8 to 10 percent annual return versus buying something on a credit card that charges 15 percent annual interest is still quite big. That’s a 25 percent annual difference!

The 80-10-10 Principle

Before we see how compounding plays out with money, let’s turn to the second deceptively simple concept Pledger espouses. And it didn’t come from any of his graduate studies in finance, or the dozens of books he’s read on the subject, or even his professional work or certifications. He heard it twenty years ago from his pastor at church. One Sunday his pastor said, “My experience watching people going through life tells me this. The single best indicator of whether they will be financially secure, have a low level of stress, and maintain a healthy marriage is if they follow the ‘80/10/10 principle.’ And that principle simply states that you should live on 80 percent of your income, give 10 percent to your church or charity, and save the remaining 10 percent.”

In his two and a half decades of working, studying, and teaching in his field, Pledger has never heard a simpler framework for guiding people to live within their means. Most of the courses he’s taken and books he’s read teach sophisticated methods to invest the 10 percent (or whatever amount) one saves. But like the compound interest concept above, most just assume that everyone knows that in order to invest money, you have to save it first. And his observation (along with his pastor’s) is that a significantly large percentage of people fail to do that. “As a result,” he explains, “when they have a flat tire, or a tree limb falls on their house, or they have an unexpected medical problem, they’re unprepared for it. So it causes stress and often trouble in their marriage.”

The Story of Jack and Kate

Once Pledger’s students understand these two basic concepts, then he’s ready to bring them both together with a story of two hypothetical recent college graduates. We’ll call them Jack and Kate. Let’s assume both are twenty-one years old. And to make the math easy, we’ll assume each earns $48,000 a year for their entire working career, which is a little below the median household income in the United States.

Kate understands both the compound interest and 80/10/10 principles well and puts them to use for her benefit. She saves 10% ($4,800 a year, or $400 a month) and invests it wisely every year, earning an 8 percent return until she retires at the age of sixty-seven.

Jack, on the other hand, understands neither principle. Like many people, he spends more money than he makes every month by using credit cards to buy things he can’t afford. We’ll assume that he spends all the money he makes each month, plus an additional $400 a month on his credit card, for the first four years after college. With a typical 15 percent interest rate on credit cards, Jack is now almost $24,000 in debt, not an unusual amount for people in the United States with a history of bad financial decisions. Let’s then assume that Jack wises up and realizes he can’t continue down this path. Instead of spending more than he earns, he makes major changes in his spending and manages to save $200 a month for the next four years that he can use to start to pay down his credit cards. That helps.

But since $200 isn’t even enough to cover the interest, his total debt continues to grow.

By the time Jack gets to the age of twenty-nine, let’s assume he finally manages to start saving $400 a month, just like Kate has been doing for eight years now. Except with Kate, that $400 a month is getting invested and growing for her. For Jack, he’s using it to pay off his credit cards, which he owes close to $30,000 on now! That $400 a month is right around the minimum monthly payment, enough to cover all the interest and reduce the principal of the debt just a little each month. At that rate, it takes Jack twenty years to pay off those credit cards he spent only four years running up. And in that time, he’s paid more than $100,000 to his credit card company because of the $19,000 worth of stuff he bought back in his early twenties. Now he’s forty-nine years old and is back to a net worth of zero, exactly where he and Kate started twenty-eight years ago.

Jack and Kate continue to save $400 a month until they reach the standard retirement age of sixty-seven. And with Kate’s smart 80/10/10 living, that $400 a month she put away for forty-seven years added up to a total of $225,000 saved. But because of the magic of compound interest, she actually has more than $2 million in her retirement account! Kate retires comfortably and confidently.

Jack, on the other hand, only has about $200,000 in his retirement account, only one-tenth as much as Kate. Said another way, Kate has ten times as much money saved for retirement as Jack. And while his $200,000 may sound like a lot of money, with all the inflation between college graduation and retirement, that money won’t last long, and soon he’ll be completely broke again.

What if Jack wanted to keep working past sixty-seven to save up as much money as Kate? How long would that take? It would take another twenty-eight years! He would have to work until he’s ninety-five years old to save up the $2.2 million Kate had at sixty-seven.

Think about that. Here we have two people the same age with the same income. And for most of their adult lives (starting at age twenty-nine), they both saved exactly the same amount of money, $400 a month. It was only the first four years that Jack was spending on credit cards while Kate wasn’t. And then for another four years he saved, but not quite as much as Kate. Those early eight years cost Jack $2 million, or twenty-eight years of his life, whichever way you want to look at it.

And what did Jack get for that $2 million he gave up? He probably got a fancier car and a slightly larger apartment between the ages of twenty-one and twenty-five. Certainly not worth $2 million or twenty-eight years of extra work in his life. But people make those kinds of decisions all the time. The reason is they don’t realize the enormous cost it will have on them forty-five years later. Once you understand Pledger’s two principles and the story of Jack and Kate, you’re in a much better position to choose.

Will you be a Jack? Or will you be a Kate?

As with all of these stories, I encourage you to share this with your kids, and then have a discussion about it. Here are some questions to get you started.

  1. Are you surprised at how much money the pennies added up to after a month, or how high the folded paper would stack? Try to calculate those numbers yourself and see what you come up with.
  2. What age do you want to be when you retire?
  3. What are some other things Jack could choose to do without in order to save as much money as Kate?
  4. Do you think you’ll grow up to be a Jack, or a Kate?
  5. What kinds of things does it make sense to go into debt to buy?

[You can find this and over 100 other character-building stories in my book, Parenting with a Story.]

PAS square profile Paul Smith is one of the world’s leading experts on business storytelling. He’s a keynote speaker, storytelling coach, and bestselling author of the books Lead with a StoryParenting with a Story, and Sell with a Story.

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