Most of my five children enjoy drinking coffee. Not just any old cup of joe, mind you, but a premium cup of java from one of the popular coffee chains. When they place their orders, it sounds like they’re speaking in a foreign language.
These cups of fancy coffee can cost upward of $5 or more. Meanwhile, I calculate my standard cup of home-brewed coffee at about 10 cents.
How much is that special brew really worth?
I try to get my kids to think through the benefits of saving some money by buying a less expensive caffeinated drink or—heaven forbid—trying a cup of their dad’s home brew. As you can see in the graphic below, each special cup of coffee can really add up over time.
Compounding: One cup of coffee at a time
* Source: Ashley Rodriguez, 2016. The average cost of coffee in your city. Accessed May 1, 2017, at http://www.baristamagazine.com/average-cost-coffee/.
** Invested in a low-cost, diversified Roth IRA. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a Roth IRA are tax-free if you are over age 59½ and have held the account for at least five years; withdrawals taken prior to age 59½ or five years may be subject to ordinary income tax or a 10% federal penalty tax, or both.
This hypothetical illustration does not represent the return on any particular investment, and the rate is not guaranteed.
Say you spend $3.50 a day on a cup of premium coffee. That’s about $105 a month, which is $1,260 a year. If you invested that money in a low-cost, diversified account instead, you’d have an estimated $106,000 after 30 years. I don’t think anyone would pay $106,000 for coffee! I know Warren Buffett certainly wouldn’t.
As a young man, Buffett wondered if he wanted to spend $300,000 for a haircut.1 By getting his locks trimmed every five weeks instead of four, and spending $18 instead of $25, Buffett estimated he’d save an estimated $300,000 over his lifetime.
A few bucks here, a few bucks there … can pay big over the long term
Small decisions, such as passing on premium coffee, can make a big difference down the road. With an extra $106,000 saved, you may be able to take the family vacation you’ve been putting off or even retire a few years earlier than you originally planned.
And it’s not just about investing more. It’s also about investing early on.
Procrastinating can be costly
A few years ago, we quantified the procrastination penalty by determining how much money investors could potentially miss out on by delaying their annual IRA contribution to the last minute. We found that investors who waited until the tax-filing deadline to make their IRA contribution for the previous year, rather than making it 15 months earlier, could’ve potentially lost out on $15,500 over 30 years.2
“Procrastination penalty” over time ($165,000 contribution over 30 years):
Notes: This hypothetical example does not represent any particular investment. The rate is not guaranteed and is provided for the purposes of illustration only. All figures are in today’s dollars. “Early bird” contributes January 1 of the tax year. “Last minute” contributes April 1 of the following year. Figure assumes each investor contributes $5,500 for 30 years and earns 4% annually after inflation. Projected balances are as of April of the ending year, when the procrastinating investor makes the final contribution. The final account balance does not reflect any taxes or penalties that may be due upon distribution. Withdrawals from a traditional IRA before age 59½ are subject to a 10% federal penalty tax unless an exception applies.
Compound interest is the eighth wonder of the world
Albert Einstein said, “He who understands it, earns it … he who doesn’t … pays it.” The phenomenon of exponential growth as your returns build upon themselves over time is nothing to scoff at. Time is the biggest advantage many investors have.
Next time my kids are in need of a caffeine fix, I’ll be right there, ready to offer up a cup of my home-brewed coffee (and my insights on compounding). I may not dissuade them from buying a cup of premium coffee this time around, but I’m optimistic that I’ll get through to them eventually. Time is on my side.
1 Alice Schroeder, 2008. The Snowball: Warren Buffett and the Business of Life. New York: Bantam Books.
2 Vanguard, 2014. Are investors subjecting themselves to the “procrastination penalty”? Valley Forge, Pa.: The Vanguard Group.