The Importance of Time in the Market

Albert Einstein is often credited with saying, “Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t pays it.” This is perhaps why it is often said that time in the market (not timing the market) is paramount to our investing success.

Yet, despite the wonder of compounding interest, the phenomenon of compounding interest is not easily grasped.  A famous story illustrates this. It goes something like this:

There was once a king in India who was a big chess enthusiast and had the habit of challenging wise visitors to a game of chess.  One day a traveling sage was challenged by the king. The sage, having played this game all his life, all the time, with people all over the world, gladly accepted the king’s challenge. 

To motivate his opponent the king offered any reward that the sage could name.  The sage modestly asked just for a few grains of rice in the following manner: the king was to put a single grain of rice on the first chess square and double it on every consequent one. The king accepted the sage’s request.

Having lost the game, and being a man of his word, the king ordered a bag of rice to be brought to the chess board. Then he started placing rice grains according to the arrangement: 1 grain on the first square, 2 on the second, 4 on the third, 8 on the fourth, and so on.

Following the exponential growth of the rice payment, the king quickly realized that he was unable to fulfill his promise because on the twentieth square, the king would have had to put 1,000,000 grains of rice. On the fortieth square, the king would have had to put 1,000,000,000 grains of rice. And, finally, on the sixty-fourth square, the king would have had to put more than EIGHTEEN QUINTRILLIAN (18 zeroes) grains of rice, which is equal to about 210 billion tons, and is allegedly sufficient to cover the whole territory of India with a meter thick layer of rice.

And so, the sage became the wealthiest person in the world.

Savings Rate

What we can take away from our chess lesson is that compound interest is logarithmic in nature, not linear. The longer we give compounding interest time to work, the more wonderful – as Einstein put it – it becomes. Whether Einstein said this or not, the truth remains. Compound interest is a major determinant of how successful we are financially.

This is important for anyone to understand, but it is really important for physicians. Why? While others outside of medicine may start saving in their 20s, most doctors start saving for their financial independence in our 30s after completing training. We are already behind the eight-ball, which gives us even less time to learn this vital lesson.

This is most readily seen when we investigate the importance of a steady savings rate. Let’s take a look.

The 2 Million Dollar Thought Experiment:

Our goal in this thought experiment is to get to $2 million dollars. While $2 million would only produce around $80,000 per year assuming a traditional 4% withdrawal rate, the point stands. And it cane be applied equally well to a higher annual savings rate than we see below.

Here are the assumptions.  We save 50K each year and earn 8% interest growth.  Given these assumptions, it would take us 19 years to get to that goal (we would actually be sitting at $2,072,313 at the end of year 19).

Here is how to understand the results of our study:

The First Decade

The first decade is primarily composed of a steady savings rate that will account for the lion’s share of our savings.

Even after ten years of savings, our annual savings rate (that $50,000 we save each year) accounts for ~70% of the total of our accumulated savings.

What can we take away from this?

• This means that the major determinant of our retirement nest egg in our early years is our savings rate (it accounts for 70% of our savings at 10 years).
• With these assumptions, we are not even halfway to our goal of $2,000,000 in TEN years of saving.  In fact, we stand at less than $800,000.
• We have to accumulate another 1.2 million dollars in 9 years.

The next decade is where the magic happens.

The Second Decade

In the chart, you’ll notice that year 17 is the break-even point where the total amount saved from our contributions starts to dive below 50% of the total value, and compound interest starts taking over as the predominant factor determining our total savings.

What we can learn from this is that the further along we get, the less our savings rate has to do with our total accumulation. This is because compounding interest begins to shine from all those hard years of saving early.

This is one of the many ways that the rich get richer.  Once you’ve saved “enough” your compound interest starts working overtime for you. The sooner you get started, the more wonderful compounding interest becomes.

Saving Early Matters

For those that prefer visual representations, the following figure may explain it better. We have extended this out to 30 years to further illustrate the extent that saving early matters.

The blue bars are the % of your total savings that comes from the money you have saved (i.e. your contributions).  The orange bars are the % of your total savings that comes from compound interest.

Time in years is on the X-axis, percentage of your total savings is on the y-axis. Note that the first year you start investing the entire bar (100%) is blue, because all of your savings came from your contribution from that first attending paycheck.

As noted earlier, in year 17 these two points (the blue bar and the orange bar) are even at 50%.  From that time point forward, compound interest is more responsible for your total savings than your contributions.

What happens if we extend the math further?  Well, after 30 years, this savings plan ($50,000 per year for 30 years) was started, the total savings would be $5,641,161. Assuming the same 4% withdrawal rate that was mentioned earlier, this would then provide ~$224,000 in retirement.

Of this $5.6 million total, 73.5% would be due to compound interest (or $4,164,161), and only 26.5% would be from your contributions (a total contribution of $1,500,000, or 30 years at $50,000).

You read that right. You contributed 1.5 million dollars over 30 years, which turned into over 5.6 million dollars.  That is the power of time in the market, just like playing chess for rice.