January 11, 2004

Investing 101: Letting your money work for you

In one of history's most famous real estate blunders, the Native Americans of New York agreed in 1626 to sell all rights to Manhattan Island for the equivalent of $24 in trinkets and beads. Mention of this peculiar fact at a party often results in a joke or two at the Native Americans' expense, possibly followed by a tinge of remorse among the more moralistic. Before feeling too guilty about this, though, one should realize that the Native Americans may in fact have gotten the better end of the deal. Had they chosen to invest this $24 at 8 per cent interest, compounded annually, today they would be sitting on a fortune amounting to no less than $103 trillion, almost 10 times the GDP of the United States. Needless to say, this dwarfs the present value of Manhattan's real estate, all the while freeing the Native Americans from having to deal with tenants and struggle with rent controls.

Is this all a little unreasonable? Yes. Not only does it require the Native Americans to convert their proceeds entirely to cash and not touch a penny of their money for almost four centuries, it also assumes they would have been able to invest their funds in a vehicle giving an average annual yield of 8 per cent. Whether such a vehicle existed in the 1600s is not certain. However, whether one exists today is. For all the ups and downs, doomsday predictions, terrorist attacks, and corporate scandals, not to mention two world wars, the crashes of '29 and '87, and the Great Depression, the U.S. stock market has averaged an incredible real return of 8 per cent each year over the past century. To answer a commonly asked question, yes, it is gambling—except in this case, you're the one with house odds. If you gamble long enough, the laws of probability are bound to eventually start working in your favor. So, while the scenario above may not have been completely realistic, it is nevertheless a startling example of the power of compound interest, what Benjamin Franklin described as "the eighth wonder of the world" and Einstein is said to have called "the greatest mathematical discovery of all time."

In conjunction with the idea of compound interest is the economic principal of "opportunity cost," or what one is forced to give up in doing something. In making any purchase, one gives up not only the dollar amount of the price of the good or service, but also the total value of that dollar's future interest, which, as seen in the example above, is far from negligible. The combination of these two principals makes for a very strong case for investing. Consider the following example:

Jack and Jill, two U of C grads, landed similar jobs with comparable salaries. After the two of them had had several years to get settled and pay off their loans, they both began to think about investing for retirement. After much deliberation, Jack eventually came to the conclusion that he really liked Gucci. He was young, retirement was a long way off, and, after all, he thought, "You can't take it with you." Jack saved nothing, at least for now. Jill, on the other hand, also liked Gucci, but eventually came to the decision that investing might make her better off in the long run. Starting at age 25, she invested $5,000 a year in stocks. For a time, all was well—Jack spending, Jill investing.

Twenty years later, tragedy struck. Jill suffered a horrible accident walking up the hill to fetch a pail of water, and was paralyzed from the waist down. She was forced to change careers, and although she still made enough to support herself, she could no longer invest for retirement. It was not until then, at age 45, that Jack finally decided to get his act together. In an effort to catch up to Jill, he resolved to invest $10,000 a year.

Twenty years after this, at age 65, Jack ran into Jill and nonchalantly mentioned that he had built up a retirement account of approximately $494,000. He was well aware that not only had he invested twice the amount that Jill had ($200,000 vs. $100,000), Jill had not been able to invest an extra penny for the past 20 years. His smug demeanor quickly left him, however, upon learning that in spite of all this, Jill was now a millionaire—her regular investments from a young age had grown to approximately $1,152,000. Disgusted at hearing this, Jack tramped off and bought another Gucci shirt.

As this hypothetical (yet not entirely unrealistic) example proves, often the single most important investment decision is not what but rather when. The key to "the greatest mathematical discovery of all time" is time—and the time to begin investing is now.