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The Miracle of Compound Returns - YouTube
Channel: Marginal Revolution University
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♪ [music] ♪
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- [Narrator] Previously,
we learned about opportunity cost.
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But how can this concept
help us save smartly?
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We'll dive into an example
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illustrating the miracle
of compounding,
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and use opportunity cost
to understand the importance
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of saving and investing
early and often.
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Let's take these two
investment scenarios.
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In the first scenario,
meet Myopic Mary.
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She starts saving in her 30s,
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and by age 45 has $20,000.
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She then invests this money
in a retirement fund
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that earns a 7%
annual rate of return
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and doesn't touch her investment
until retirement.
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How large will Myopic Mary's
$20,000 grow to be
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if it's growing at 7% for 20 years,
until she turns 65?
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For simplicity,
we'll use the Rule of 70,
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which allows you
to quickly approximate
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how long it will take
for an investment to double in value
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given a specified rate of return.
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To see how many times
Myopic Mary's $20,000 will double,
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simply divide 70
by the rate of return or growth.
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So 70 divided by a rate of return
of 7 equals 10,
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which means her money doubles
approximately once every 10 years.
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Since she's investing for 20 years,
her money doubles twice.
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Myopic Mary's $20,000 doubles
to roughly $40,000
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by the time she's 55,
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and doubles yet again to $80,000
by the time she's 65
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and ready to retire.
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So she started with $20,000,
did not save a single cent more,
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reinvested her returns,
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and, after 20 years,
ended up with about $80,000.
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Not too bad!
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Now, onward to scenario two.
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Imagine Myopic Mary
goes back in time 10 years,
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and becomes Meticulous Mary.
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Meticulous Mary
starts saving in her 20s
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so that by age 35 she has $20,000.
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At this point, she invests
her money in a retirement fund
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that earns a 7%
annual rate of return
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and doesn't touch her investment
until retirement.
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Our Rule of 70 calculations
are exactly the same
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as scenario one.
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Given a 7% annual rate of return,
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Meticulous Mary's money
will double every 10 years.
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The only difference
from scenario one
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is that Meticulous Mary's money
will double three times
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instead of two times.
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She now has 30 years
until retirement, instead of 20.
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Meticulous Mary's $20,000
will double to $40,000
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by the time she's 45,
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will double again to $80,000
by the time she's 55,
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and will double yet again,
to $160,000, by the time she's 65.
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So, let's recap.
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Both Marys, Meticulous and Myopic,
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invested the exact
same amount, $20,000,
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at the exact same
rate of return, 7%.
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The only difference between
these two scenarios is time.
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Meticulous Mary started investing
just 10 years earlier,
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and that led
to $80,000 more dollars.
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How can that be?
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It's the miracle of compounding!
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Meticulous Mary started saving earlier,
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and that means that
when her investment reached $80,000,
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she had one more 10-year period,
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one more doubling period
still to go.
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And it's that last doubling
that is the biggest doubling.
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When people start to save,
it often seems slow and pointless,
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because things
don't change all that much.
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The rate of absolute change
gets faster and faster.
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This is what people mean
by exponential growth.
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And keep in mind,
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Meticulous Mary
stopped saving at 35.
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Imagine if she had continued
contributing to her retirement fund
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until she retired.
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That would be an extra 30 years
of additional savings,
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and additional compound returns.
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Now let's think about this
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through the lens
of opportunity costs.
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Every dollar Meticulous Mary had
and invested at 35
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turned into $8
by the time she was 65.
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Contrast this
with poor Myopic Mary.
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Every dollar she had
and invested at 45
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only turned into $4 at 65.
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Quite the difference!
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But the real takeaway
from these two scenarios
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is not about Meticulous
or Myopic Mary.
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The real takeaway is that
you should be saving and investing
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early and often.
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And yes, I understand --
saving is hard to do.
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And where should you even
save and invest?
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Fear not.
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We'll cover some helpful saving tips
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and details
about common retirement plans
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in future videos.
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- [Narrator 2] Check out
our practice questions
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to test your money skills.
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Next up, we'll cover
some specific saving tips
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so you can invest early and often.
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♪ [music] ♪
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