Let’s talk about a subject it seems few people understand: the importance of compound interest.
In my work, I interact with hundreds of college students each year. Each fall, I teach a class for seniors. The content deals with job searches and living as an adult. The class is open to all majors and one of the more shocking topics we discuss is saving for big goals.
Saving starts with two aims: the first is an emergency fund to cover three to six months of expenses, and the other focuses on longer-term goals. These latter goals include retirement, which is the biggest long-term goal for most of us, and other things such as down payments on houses, college funds, and dream vacations.
For most students, it is the first impactful conversation they’ve had on the subject. I know some of you will argue that students had classes in high school where this was introduced. That may be true, but for most of them, while the content gave them an exposure to the topic, it wasn’t relevant to them. As the students I’m teaching are graduating in three to nine months, the real world is knocking on their doors and they are both terrified and eager to discuss it.
So let’s talk about retirement. While 22-year-olds think they have plenty of time to begin saving for a goal that won’t be a reality for at least 40 years, they learn they don’t. For most people, the days of going to work for organizations with defined pension plans are over. And we hear over and over that Social Security is going to run out of money. So if you cannot rely on a pension plan and you may or may not have retirement income from Social Security, it’s up to you to save your retirement money.
Most people don’t understand the stock market and many may not trust it. But if you look at the stock market historically, it is the best way to save for long-term goals. So we show the students this graphically, pointing out the Great Depression of the 1930s and how the market rebounded. More recently, they see the downturn in the late 2000s and how the market bounced back again. We talk about not trying to time the market. Don’t get out of the market when it tanks. You’ll probably lose the chance to easily recover if you do.
We also discuss inflation. If I can buy a candy bar today for $1 and inflation is 3 percent this year, then that candy bar will cost me $1.03 next year. If I put all of my money under my mattress, then my money loses purchasing power. If this happens year after year, then I’m in real trouble when I need my money, as it won’t be worth as much as it is today because of inflation annually.
We discuss compound interest and why putting your money in growth opportunities like the stock market is a good idea.
Here’s how compound interest works: If I invest $1,000 this year and my return is 8 percent, then next year my investment is worth $1,080. If the return stays 8 percent the second year, then I have $1,166.40 at the end of that year. And it keeps growing like that.
OK, so we know we cannot expect 8 percent returns annually. Some years it’s higher, sometimes it’s lower. But over time, we can expect, based on historical data, 8 percent or so, depending on one’s risk tolerance.
So to both have money saved for retirement and to ensure your purchasing power remains similar to what you have today, investing in the stock market is the way to go. But the key is to start early.
That’s what most young people don’t understand. They think they have years to start. Fortunately, those who are taught these simple lessons get it, and have options for retiring on their terms. What about you?
Lynne Richardson is the dean of the College of Business at the University of Mary Washington.