Having a good savings strategy is essential for long-term financial security. There are a few things that members of the Millennial Generation can learn from previous generations, and one of them pertains to treating savings as investments. In the United States, math teachers in elementary schools use savings as an example of real-life multiplication. Still, the problem is that many of these examples are not grounded in reality. We are talking about the story of starting a savings account with just one penny and doubling the deposit each day.
Doubling your savings each day works out to $0.64 at the end of the first week. By the end of the second week, you are looking at $81.92, and these exponential savings will yield more than $20,000 when the third week finishes. Once you reach the end of the month, your account balance will reflect more than $5.3 million. This is clearly a fantasy scenario.
A Realistic Scenario for Savings Strategies
The math does not lie with this savings strategy, but the practical reality of this hypothetical situation is that not many of us can generate the kind of income needed to make it to the middle of the third week. Even if you are an active investor, it would be very difficult, if not outright impossible, to generate 100% profits on a daily basis. Major Wall Street investors are not able to generate more than 20% daily gains with a diversified portfolio and a team of professional analysts and fund managers.
A more realistic savings strategy that could perhaps be taught to high school students is compound interest with actual rates, longer investment horizons, management fees, and capital gains taxation. Even the aforementioned penny-doubling example would fail to make even a million dollars in a month.
Real Talk About Compound Interest
Compounding is an investing strategy that wealthy families and investors masterfully use, but it is actually open to just about anyone who wishes to take advantage of it. Billionaire investor Warren Buffett is probably the best example in this regard; approximately half of his $100 billion net worth has been generated through compounding, which he has strictly adhered to since his early teens. This is the number one real-life rule of compound interest: The earlier you get started, the more wealth you will be able to generate.
As previously mentioned, there is simply no way you will be able to double your deposits on a daily basis constantly. The reality of compound interest accounts in 2021 is that even the highest rate you will find is less than 1% in the United States. The best you could hope for in October 2021 was 0.60% for a high-yield savings account or 0.55% for a money market account. These are the rates you should input when using our Compound Daily Interest Calculator, and we will use one of them in our example below:
- You start out with a $100 deposit plus a commitment to set aside $5 each day towards a contribution.
- Your compounding rate of 0.60% will be applied daily, and the bank will take care of reinvesting profits for you.
- In one year, you would have more than doubled your investment to $230.42, and your investment will not be taxed at the high 30% capital gains rate because it is a savings account.
You can also adjust the parameters of the compound interest calculation according to your means and investing horizon. For example, if you are able to contribute $150 each month to your compounding account, you would generate $18,657 in 10 years.
Compound interest can also serve as an excellent tool for financial retirement planning. For example, if you start compounding at the age of 20 and stick to the savings plan above, you would have $86,106 by the time you are able to claim your Social Security pension.
The Importance of Money Management and Disciplined Contributions
Becoming a millionaire from your compound interest strategy is possible, but it will require more effort than the examples cited above. The contributions you make to the account are the keys to financial success. Instead of sticking to $5 a day for life, you should always look for opportunities to increase these amounts. Salaried employees and wage earners can do this whenever they get raises and bonuses. Active traders should be depositing profits that they realize from the base amount they use to take market positions; in fact, many online retail brokers offer compounding accounts, typically of the money market kind, where clients can let their money grow in a passive manner.
As for money management, you can’t beat a compound interest strategy. All investors and savers should have a supply of emergency cash that would cover three months’ worth of household expenses in case of emergencies; compounding accounts are the best accounts where you can keep these reserves because you know that you will not be making withdrawals too often, only when there is a pressing need to do so. Even if you only withdraw half of these reserves when you are in between jobs, the rest of the money should earn compound interest as you get back on your feet and start replenishing the emergency fund.