May 23, 2004|By CAROLYN BIGDA

I RECENTLY heard the woeful story of a young man who spent $1 million on a new Trans Am.

The sticker price of the car was actually $20,000, which he funded by cashing out his 401(k) when he switched jobs a few years ago. But as a financial planner pointed out, had he reinvested that money in a tax-deferred account until he retired, it likely would have grown to $1 million.

This young man strayed from the path of millionaire status because he failed to consider the power of compounding.

Dubbed by Albert Einstein as one of the greatest forces that exist, compounding can be incredible for young investors. It shows that with time, an investment's growth accelerates rapidly due to compounded interest, or the rate of return applied year after year not only to the principal but also to the accumulated gains.

Let's do the math: At age 22, say you invest $3,000 and do so each year until you're 65 years old. At an 8 percent rate of return, that $3,000 will be worth over $1 million when you retire. Had you waited to start investing until the age of 30, you would reach only half the sum.

So, for additional money up front, you made half a million dollars more. To get that kind of return later on in life, you have to put aside a lot more than $3,000 a year.

You can experiment with this mathematical wonder on Web sites such as www.fool.com, which provides calculators.

Another trick for estimating how fast your money will grow is called the rule of 72. By dividing the rate of return into 72, you learn how many years it will take to double your money. In our case, an 8 percent return requires nine years.

Still, you might argue that it's impossible to put money away for retirement when you're 20-something and not making much of a salary. And no one will deny the need to pay rent, buy groceries and enjoy life a little.

But retirement is a major expense that increasingly is becoming our personal responsibility. You can no longer assume that Social Security and pension plans will cover all of your needs.

"Do you want to rely on government institutions to provide for your retirement or make some small sacrifices now to create your own secure retirement?" asks Randy Reeves, an investment center manager for Charles Schwab.

But there's more to building a nest egg than saving $3,000 a year and letting compounding do its work.

First, you need to pay down high-interest debt, such as credit card balances that can carry interest rates in the 20 percent range. That way, any earnings you gain in the marketplace are not wiped away by huge credit card bills.

Second, have realistic expectations. If a mutual fund posts a one-year return of 25 percent, that's great. But how has it performed over 10 years? And how much would your money really be worth?

Most profiles of mutual funds report only the average rate of return, which is done by adding up each year's performance and dividing by the number of years. This number may give you a rough estimate of how much your money would grow, but it often overstates the value because it does not reflect the compounded decline of your money in years with negative returns.

You also have to consider inflation and taxes, which diminish earnings.

But before you get too bogged down in economic and market forecasts, many advisers say a 6 percent to 8 percent annual return is a reasonable expectation.

Final advice: Be patient.

"If you picture your investments as a line on a graph, the first half does not grow very fast," says Phil Cook, a certified financial planner based in Torrance, Calif. "But the second half accelerates, creating a steep slope of the curve, and pretty soon you're making substantial growth just from your earnings."

E-mail Carolyn Bigda at yourmoney@tribune.com.