Two important concepts about building wealth and the story of a pair of boots that cost $24,000

-Two of the most important concepts for building wealth and a story about a pair of boots that cost $24,000. [music] Hi, I’m Troy Sharpe, CEO of Oak Harvest Financial Group, CERTIFIED FINANCIAL PLANNER™ Professional (CFP®), host of the Retirement Income Show, and author of the upcoming book Core4.

Einstein called compound interest, the eighth wonder of the world. Compound interest is when the money that you invest earns interest, and then in future years, that interest starts earning interest. It’s one of the most powerful concepts you need to understand in order to build wealth over the long term.

The best example that I have for this is what we call the penny example. If I were to say, would you want $0.01 that doubled every day for a month or a $1 million, which would you take? The $0.01, after 10 days, is only $5. The $0.01, after 20 days, is about $5,000. The $0.01 after 30 days is over $5 million. If you chose the $0.01 you chose correctly. That is the best illustration of how compound interest works over time.

That’s an unrealistic interest rate. Assuming $0.01 doubles every day, that’s 100% rate of return. Those aren’t realistic rates of return in today’s marketplace. What you can expect to earn in the marketplace is 3%, 4% for conservative investments, 5%, 6% for moderate-type investments, and maybe 8%, 9%, 10% percent with aggressive investments. We have a chart. I want to go through and show how this applies over different levels of interest rates earned and also different timeframes.

If we start with 3% interest. If you invest $10,000, over 10 years, you’re going to have about $13,000. Over 20 years, you’d have about $18,000, over 30, $24,000, and over 40 years, you’d be left with $32,000. That’s not a great rate of return over the long term for your money. 3% is good for short-term investments, things that aren’t going to lose a lot of money if things go bad, but 3% isn’t really going to build you wealth, you need to get to the second half of this chart over here to really build wealth. The purpose of this chart is to really show you the power of compound interest at varying rates. This is why we need to invest. If you look at the 6% example, $10,000 10 years later, is about $18,000. 20 years later, it’s about $32,000, then $57,000 and $102,000. These numbers aren’t exact, they’re rounded, but they’re close, they’re approximate. Now we get into the good stuff. If you can average 10% a year, over 10 years, your $10,000 only turns into $26,000. After 20 years, it’s $67,000, 30 years, $174,000, and 40 years, almost $500,000, 452,000.

Compound interest is like a snowball, when the snowball starts at the top of the mountain, it gets going, it gets going. As it goes down, it gets bigger and gets bigger. We have to understand that compound interest takes two components; it takes the interest that you earn, but also the time that you have to invest. Time is the most valuable element we all have and this is why it’s important to start investing, to start saving, to start learning about money at a younger age. The sooner you start, the more time you have to allow the power, what Einstein called the eighth wonder of the world to work in your favor.

I had a client, he came in to see me. This is probably been about five or six years ago. He has worth $25 million. One of the first things he said to me, he said, “Troy, I’ll give you every single dollar I have, you just have to do one thing.” I said, “What’s that?” He said, “You have to figure out a way that I could be your age and you could be my age.” He was willing to trade everything, $25 million, if there was an opportunity where he could just have more time. Time is the most valuable asset that we have when it comes to investing. The sooner you start, the better you’re going to be. This example here, we wanted | to show just how powerful this concept is, looking at a couple of different scenarios. The first one, if you start with $10,000 and you only invest $200 a month. Let’s say you come up with $10,000, you save, you do the right things and you have $10,000 and then you start to save and invest and you’re able to contribute $200 a month for the next 40 years. If you can earn 7% on your money, that’s going to turn into $628,869. Compare that to somebody who says, “You know what? I’m going to wait until I make more money, till I have a better job, till I have more security and then I’m going to start to save and invest.”

They accumulate $200,000 and they decide, “Okay, I’m going to start saving also $200 a month.” 15 years later, at the same 7%, they only have $612,116. The person here starts with $10,000 with a longer timeframe, same interest, ends up with more money. This really illustrates the power of time when it comes to investing. Of course, if we go back and look at the previous chart, it also matters what interest rate that you earn. There’s a significant difference in outcome based on if you’re earning 3%, 6%, 7%, or 10%. Where do you get these types of returns? Historically, if you invest in the stock market, you’re looking at anywhere from 8% to 11% average annual rates of return. This is over the long term and this is for the money that you don’t need anytime soon. Stay tuned to the channel, make sure to subscribe because we’re going to have a lot of videos that talk to you about how to invest in the stock market, how to earn these types of long-term rates of return.

You may need money for the short term as well, you may need money in the next one years, two, three years. You may have a wedding coming up, you may want to buy a home, you may have children that are going to college. That short term money, you’re not going to be able to achieve these higher rates of return unless you take excessive risk in the sense that, hey, you could lose some of that money and then not be able to afford your down payment, or maybe pay for your wedding which would be horrible. What we want to do with our savings is we want to come up with a plan that gives us confidence and makes us feel secure, that we’re being wise with our money, that we’re making good decisions. I had a client come in the other day, and she asked me, “How much should I have in savings?”

 

She had about $25,000. Her situation, like everyone, is unique. She didn’t have any children, she didn’t have a home where she had to worry about an air conditioner going out or having to put a new roof on. Her expenses were about $4,000 a month. For her particular situation, it made sense to keep about $10,000, maybe $12,000 in the bank. She had a very secure job, she felt like she was not in jeopardy of losing it anytime soon. The rest of that money along with some of some other funds she had, we wanted to get it invested so we could earn these greater rates of return. The short-term money, we want to keep safe. The money she may need for the next three months, the next three years, we want to keep that a little bit safer. When we look at a savings plan, you really have a couple of places that are primary when it comes to where you should be putting your money. If you have a job and you’re working and your company offers a 401k, you have two components, you have inside the 401k, most of you do. Not all companies have this Roth component, but they’re starting to become more popular. If you work for a larger company, you almost certainly have this Roth component.

When you save money for the long term in your 401k, you either put it into the qualified section, this means you get a tax deduction today and when you take money out in the future, you’ll have to pay income taxes. You can put it into the Roth part of your 401k, and this is how you really build tremendous wealth over time and keep the wealth. You’ll pay income taxes on the money you make today, but it’s going to go into the Roth and it’s going to grow tax-free. Later on, down the road, you’re going to be able to take all that money out tax-free. This is the first place for long-term saving and investing that you can achieve these rates of return is inside your 401k. The primary difference between the traditional or qualified part versus the Roth is this money, you get a tax deduction upfront for, but you pay income taxes later.

This money, you pay taxes today, but it’s going to grow tax-free and it’s going to be tax-free forever. You almost always want to put into your 401k at least the amount that will get you the full company match if your company offers you a match. Any excess savings that you want to make, you want to put into a brokerage account. This is going to be your short-term money, but also your long-term money. You can open up an account at TD Ameritrade, at Fidelity, at Schwab, and any of these places can house your brokerage account. If you look at the brokerage account, it’s really broken down into two components. It’s one account, but if you want to make a down payment on a home, maybe start a business in the next couple of years, maybe pay for your wedding, like I said, and you have this one to three-year part or one to three-year bucket, this is going to be more conservative, safer investments that don’t have the potential to lose.

In your brokerage account, you also want stocks, you want long-term growth potential and this is going to be the three-plus years section of your brokerage account. Just one way to look at savings and investment over time and how you can segment the overall strategy. Of course, you can always reach out to us if you have questions about this or you want a professionally managed plan of savings and investment to help you feel confident and secure. Why we want to position the accounts like this to have taxable money, tax-free money, short-term liquid money, long-term liquid money, is because once we get down the road, this is what we want it to look like. We need to start taking income out at some point in the future. This is positioning. This is what we do every day for clients that are already retired, retirement income planning with respect to keeping taxes low. Money inside the 401k, the traditional part, when you take it out, you have to pay income taxes, and many people believe taxes are going to be much higher in the future.

We don’t have a crystal ball, but when you look at the amount of debt the country has, you look at the amount of money we spend, you look at the current tax environment today, which is the lowest that we’ve had in many many years. Taxes are likely to be higher in the future. When you take money out, you’re going to have to pay income taxes on this part. The tax-free portion that’s going to grow tax-free, you’re going to be able to take it out and you’re going to have tax-free income later. Now the brokerage account, it gets preferential tax treatment known as capital gains tax treatment. Currently, long-term capital gains are taxed at 15% whereas ordinary income tax rates can be anywhere from 10% to over 37% today. The main point here is we want diversification when it comes to the tax characteristic of our account. This gives us flexibility.

If tax rates are higher in the future, you can take from your tax-free accounts, you can take from here. If taxes are lower in the future, we can take more money out of here. When you’re saving and investing today trying to achieve these higher rates of return, it’s not just your risk and comfort level with the stock market, you also need to be preparing for the future in regards to where the money is going to come from so you’ll have more flexibility and you can pay less taxes throughout the course of your retirement. Coming back to the 401k part or the Roth part, money that you put into this account you cannot access before you’re 59 and a half. This is long-term money. If you do access it, you’re going to not only pay you income taxes on this part but you’re going to have a 10% penalty. This is an excise tax imposed by the IRS. To achieve these higher rates of return over the long term, we do need to invest in stocks. It’s the best place historically to get great returns. We need to start at a younger age. The sooner we start, the less money we need to really build true wealth over time and then we need to have a savings and investment plan that positions us for the future so we have money that we can withdraw and pay different tax rates so we have more control over the taxes.

Now bonus concept. I had dinner with a guy the other day, and we were sitting down talking and I noticed he had some brand new boots on, so I said, “Hey, nice boots.” He says, “Man you want to believe what I paid for these boots.” I said, “What happened?” He said, “I walked into the store and I was just window shopping and this pretty girl came over to me and I was about to walk out, not buy the boots but I said, “Oh, you know what, I’m going to buy the boots.”” He bought the boots to impress the girl, they cost $1500. I took a bite off my steak and I did a little math in my head and there’s a rule of 72, I’ll teach you how to do this. I said, “Wow, those boots, you know they actually cost you $24,000.” He looked at me and he said, “What do you mean?” I said, “Well, let’s say you would have invested that $1500 instead of buying those boots to impress the pretty girl.” The $1500 in 10 years would’ve been worth $3000. In 20 years they would’ve been worth $6000, in 30 years it would have been worth $12,000, in 40 years it would have been worth $24,000.

This concept is what we call the opportunity cost of the decisions that we make today. Yes he bought the boots, yes he has great shoes on his feet and spent $1500 whereas the opportunity costs that he incurred, the other opportunity that he could have taken would have been to invest that money. When he retired at age 65, it would have been worth $24,000 if he could have earned 7%. To calculate in your head, these quick rates of return, what you want to do is divide 72 by the expected interest rate, so 72 divided by 7 is 10. That means about every 10 years your money will double. 72 divided by 9 is 8 which means about every 8 years your money will double. You can use the rule of 72 to determine how long it’ll take for your money to double and in this instance, for him his $1,500 boots cost him $24,000 by the time he retires.

Thank you for watching, make sure to leave your comments down below, if you have any questions, feel free to reach out to us, visit the website at OakHarvestFG.com and make sure to subscribe, hit that little bell icon to be notified when we upload new videos so we can keep you more connected to your money and help you build wealth over time.