Bumping my head on my desk and waking up in a puddle of my own saliva was a common occurrence during my college mathematics class. Maybe it was the unintelligible accent of the graduate student teaching the class or possibly the fact that I was dumb enough to schedule the class at 8:00 AM knowing that I wasn’t going to bed until 4:00 AM from my bartending gig. Actually, it was probably neither. Math is not my bag baby. Good Will Hunting I am not. In fact I would rather take a Rambo First Blood Part II Sylvester Stallone torture treatment at the hands of the North Vietnamese and Soviets than sit through another mathematics course. To this day I have terrible reoccurring nightmares of sitting in a classroom, staring at a mathematics exam with questions that make as much sense to me as the soap operas my mother-in-law watches on the Greek channel.
I believe that understanding math is similar to having the ability to hit a curveball, either you have it or you don’t. My brother Matthew who heads our financial planning division has it; he actually (the horror) majored in it. Matthew has an interesting propensity for not saying much. For example: Matthew and his family go on a vacation to a beautiful hotel and spa on the beach. If you were to ask him how his vacation was, you would receive either the answer of “fine” or “good.” The bottom line is if you want to know the square root of 347,986, Matt’s your guy. If you want details and descriptions talk to his wife Katina. Anyway, when I asked Matthew the question years ago on how anyone in their right mind could major in mathematics, his simple response was “Math is power.” I will elaborate because Matt certainly won’t… When it comes to your finances, when it comes to your portfolio, your wallet, nothing fattens it more than math. Matthew is correct, math is power.
“The most powerful force in the universe is compounding interest.”
Attention class! I am going to make this as painless as possible. This short and sweet math lesson is all you need to know to utilize the mighty power that few people understand.
Here is the formula… A=P (1+r)^n
Where: P = the principal (the initial amount you deposit)
r = the annual rate of return (percentage)
n = the number of years the amount is deposited for
A = the amount of money accumulated after “n” years, including interest
Note: This calculation becomes much more complicated when additional contributions are made or if compounding occurs on a more frequent basis (monthly, quarterly, etc.). If you want further explanations on this formula call Matthew. I’ll be damned if the Markowski Monthly is going to induce a saliva puddle stupor so I am going to try to explain the math my way.
Here is the scenario…
Bob and Tom are good friends who are both 18 years of age and have just graduated from High School. For their graduation gifts Bob’s dad offers to put $20,000 into a savings account and Tom’s father puts $20,000 into a mutual fund. Both parents stipulate that they cannot touch the money until they are 65 years old. Bummer dude! Bob’s father feels guilty because he missed way too many Little League and High School football games so he offers to add an additional $20,000 a year into the savings account. Tom tells his father how generous Bob’s dad was. Tom’s dad reassures him not to worry he will end up ahead. “No way dude…that’s like impossible.” Tom’s dad smiles and goes back to reading his Markowski Monthly.
Let’s make some assumptions: We will assume that inflation is equal to 3% and Bob’s savings account yields the same. We will also assume that Tom’s portfolio yields 10% on top of inflation.
At their 10 year class reunion Bob and Tom compare notes and catch up with one another. Bob tells Tom that it probably wasn’t the greatest idea that he majored Ancient Literature of the Aborigine, but his gig playing the Didgeridoo at the street fair is working out great. Tom, now Doctor Tom is finishing up his residency. After 10 years of deposits Bob’s savings account is now up to $200,000 where Tom’s mutual fund account is worth $51,875.
At their 20 year class reunion Dr. Tom tells Bob how wonderful his medical practice is going and Bob, now a fully-developed sensitive pony tail guy, talks about his new gig working for Howard Dean. “The pay stinks but at least I get to work for a guy that will take down those evil Republicans, plus my savings account is now worth $400,000.” Dr. Tom tells Bob that his account is now worth $134,550.
At their 30 year reunion Congressmen Bob (D-Massachusetts) boasts to his old friend Dr. Tom that his savings account is doing very well at a cool $600,000. Dr. Tom asks Congressmen Bob if it’s really true that he has actually proposed a 75% across the board tax increase and lets his old buddy know that his account is worth $348,988.
Now at 65 years old Congressmen Bob is forced to retire (something to do with payoffs, crooked brokerage firm, an intern, and a cigar.) Dr. Tom is still working at his office part time but is devoting a majority of it to his grandchildren. After 47 years with an initial deposit $20,000, adding $20,000 a year seeing 3% a year return Congressmen Bob gets his money, $940,000 which is subsequently spent on legal fees. Dr. Tom after an initial deposit of $20,000, adding nothing else in 47 years seeing a 10% return over inflation his portfolio is worth $1,763,950; which he subsequently uses to spoil his grandchildren and makes his favorite charities very happy.
Note: If you’re wondering what Dr. Tom’s portfolio would have been if $20,000 was added annually?
Math is power! (Ask Matt.)