Today I want to revisit an investment classic written by the late Richard Russell titled, “Rich Man, Poor Man.” It shows how powerful compound interest can be.
Russell, who penned the Dow Theory Letters for nearly six decades, is one of the most respected financial writers in history. “Rich Man, Poor Man” is his most influential piece. I plan on making my three children memorize it once they’re old enough to understand the basic math.
Russell used the example of two young men:
- One started contributing $2,000 per year to his IRA at the age of 19 and stopped investing new money at age 25. He never invested another penny after turning 26.
- The second young man started contributing $2,000 per year at age 26 and continued to do so for the following four decades. Both enjoyed 10% annual returns. At the age of 65, guess which one had more money?
Almost incredibly, the first young man — who started at 19 and stopped at 25 — amassed a larger fortune than the second once you subtracted the initial investment. That’s with the second investing nearly six times as much money over a much longer period of time.
If you don’t believe me, open a spreadsheet and do the math. I didn’t believe it the first time either.
Just for grins, I wanted to see if the “Rich Man, Poor Man” numbers still work today.
Can You Use the “Rich Man, Poor Man” Strategy in Today’s Market?
When Russell first wrote the article, IRA contributions were limited to $2,000 per year. Today, the same two young men could invest $6,000 per year.
Now, the amount of the contribution doesn’t affect the outcome. Whether both invest $2,000, $6,000 or $6 million per year, the young man who started earlier always finishes ahead under Russell’s assumptions.
But are the assumptions themselves realistic? Can someone investing today really hope to earn 10% per year over the next 45 years?
Maybe not with how elevated stock prices are today. So, let’s see what the numbers look like if we assume 5% returns per year.
Assuming a 5% annual return, someone starting at 19 would need to contribute for an additional couple of years in order to come out on top. But he could still quit investing at the ripe old age of 38 and beat someone who started at 26 and continued to 65.
Playing with the numbers, someone that started investing their money at age 26 made a little over three times their money. But starting at 19 multiplied the original investment by six and a half times. And that person stopped saving before the age of 40.
Time Is the Key to Compound Interest
The lesson is clear: Time is your greatest ally when accumulating wealth.
By age 40, you’d need to invest $17,552 to make up for that $6,000 contribution you didn’t make when you were 19 (assuming 5% annual returns). By age 50, the number jumps to $28,590, and it just goes up from there.
Of course, that knowledge doesn’t do you a lot of good if you’ve already got a little gray in your hair. You can’t go back in time and force your younger self to invest.
But you can sit down with your children or grandchildren and explain to them how compound interest works. Do the math. Show them what the money they want to spend on that new iPhone or music download would be worth in 20 or 30 years if they invested it instead.
Money & Markets contributor Charles Sizemore specializes in income and retirement topics. Charles is a regular on The Bull & The Bear podcast. He is also a frequent guest on CNBC, Bloomberg and Fox Business.
Follow Charles on Twitter @CharlesSizemore.