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Teaching your Kids: The Magic of Compound Interest

To a lot of people, making smart decisions about what to spend and how to save are tedious and unpleasant chores. They're often lumped together with balancing the checkbook and choosing between complicated investment options on the list of things we don't really understand and would rather not spend our time doing.

So they're often neglected. But it doesn't have to be that complicated, according to someone who should know: Pledger Monk.

Pledger has spent a lifetime studying, managing, and teaching finance and investment. He holds a bachelor's degree in economics as well as an MBA from the Wharton School at the University of Pennsylvania and has spent the past twenty-five years as a financial adviser at one of the most prestigious investment banking firms in the world.

So it should be no surprise that he's well versed in the most modern and sophisticated financial theories and investment vehicles. But what might be surprising is that when asked what are the most important concepts about money that people need to learn, he offers two deceptively simple ideas. And the first is one you think you understand. But you don't.

As Pledger explains, "I believe one of the most important concepts in investing and finance is one that's not talked about enough. In fact, it's supposedly well understood. Even finance professors in school assume all their students understand this principle like the back of their hand. But in my experience, they don't.

The concept is this: compound interest or exponential growth. Everything in our financial system works on a compound basis. If you understand it, it can work for you to your benefit with incredible force and power. If you don't understand it, it can move you with equal force in the opposite direction."

And most people simply do not understand the magnitude of that force. Pledger believes this is because we're taught from an early age to understand mathematics in a linear fashion: two plus three, three times four, five minus one. "We can do those problems quickly off the top of our head," he explains. "But if we're asked to answer an exponential question, our minds just shut down. If I asked you what's six to the fifth power, or three to the one-fourth power, most of us couldn't even wager a guess. And if I asked what four is to the negative eighth power, you wouldn't have a clue."

So when Pledger teaches courses on investing at his local university, he introduces this topic with a couple of insightful examples. He first asks the class, "If I were to give you a penny every day in January, how much money would you have at the end of the month?" Just about everyone quickly answers "thirty-one cents."

"Correct," he tells them. "Now what if I gave you one penny on the first day, but two pennies on the second day? Then I doubled it to four pennies on the third day, and doubled it again to eight pennies on the fourth day, and so on until the end of the month. Now, how much money would you have?"

Most of the guesses he gets are in the $10 to $20 range. "Sometimes I'll get a few guesses around $100, and occasionally someone will throw out a really big number. But no matter how big it is, it's never even close to being big enough." And he can say that confidently, because the correct answer is 2.1 billion pennies. Yeah, that's billion with a "b." More than 21 million dollars' worth of pennies. He says, "You could all retire very nicely at the end of the month."

Well, next, he asks them to consider a piece of paper. "Now fold it in half. Then fold it again, and again. Now imagine folding it forty-five times." That last statement usually gets a good laugh, because most people realize you couldn't actually fold a sheet of paper more than six or seven times since it would get too bulky. But he asks them to just humor him. "How thick would it be?" he asks.

"Just to get us in the ball park, do you think it would be thicker than a good dictionary?" Some people think so. "Would it stack higher than this desk?" That turns out to be too thick for most guesses. "Higher than the ceiling?" And that's usually where the rest of the class drops out.

"The correct answer," he tells them, "is that it would be thick enough to stack from here to the moon!" He's right, and perhaps even much farther depending on what kind of paper you're folding. If the 2.1 billion penny example didn't work, this more visual example usually brings the lesson home. And that lesson is the uncommonsensical nature of exponential growth.

Well, when his students are all sufficiently impressed with its power, that's when he explains to them that every time they choose to buy something, or pay off a debt, or save and invest their money, they're making an important decision. They're choosing whether to let the power of compound growth work for them or against them. True, these examples are deliberately extreme to make a point. Nobody will pay you 100 percent interest compounded daily or extract that kind of penalty for a late payment on your mortgage. But the difference between investing money at an 8 to 10 percent annual return versus buying something on a credit card that charges 15 percent annual interest is still quite big. That's a 25 percent annual difference!

But before we see how compounding plays out with money, let's turn to the second deceptively simple concept Pledger espouses. And it didn't come from any of his graduate studies in finance, or the dozens of books he's read on the subject, or even his professional work or certifications. He heard it twenty years ago from his pastor at church.

One Sunday, his pastor said, "My experience watching people going through life tells me this. The single best indicator of whether they will be financially secure, have a low level of stress, and maintain a healthy marriage is if they follow the '80/10/10 principle.' And that principle simply states that you should live on 80 percent of your income, give 10 percent to your church or charity, and save the remaining 10 percent."

In his two and a half decades of working, studying, and teaching in his field, Pledger has never heard a simpler framework for guiding people to live within their means. Most of the courses he's taken and books he's read teach sophisticated methods to invest the 10 percent (or whatever amount) one saves.

But like the compound interest concept, most just assume that everyone knows that in order to invest money, you have to save it first. And his observation (along with his pastor's) is that a significantly large percentage of people fail to do that. "As a result," he explains, "when they have a flat tire or a tree limb falls on their house, or they have an unexpected medical problem, they're unprepared for it. So it causes stress and often trouble in their marriage." If they followed the 80/10/10 principle, they'd be much better off, and so would their marriage.

Okay, share this story with your child whenever they're old enough to start understanding about money and spending. Then have a discussion about it. Here are some questions to get you started.

  1. Are you surprised at how much money the pennies added up to after a month, or how high the folded paper would stack?

  2. Try to calculate those numbers yourself and see what you come up with.

  3. How hard do you think it would be to live on 80% of your income?

  4. With your parent's help, trying coming up with a reasonable monthly budget for how to spend your money when you first move out on your own.

Okay, in the next lesson, we'll tie both of these concepts together with an example of two similar college students and how they spent their money after graduation.

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Written by

Paul Andrew Smith