Financial Success: The Marshmellow Test, Time, and the Rule of 72

This is my second post in a series on financial planning. In my first post, I talked about investing in yourself, which you are all doing by taking an interest in this page. Today’s post will cover saving, time, and compounding, which Einstein called the 8^th wonder of the world. 

Saving is a fundamental prerequisite for successful investing. By saving and investing early and regularly, one can reap huge rewards down the road. Saving isn’t about making a lot of money. It is about the willingness to sacrifice or delay certain immediate gratification now for long term results. This applies not only to investing but being successful in all life’s endeavors.  Consider this test which was conducted in the late 1960’s by Walter Mischel, a psychologist at Stanford University.

Professor Mischel called this experiment “The Marshmallow Experiment.” In his experiment, he placed children between the ages of four and six in a room with no distractions. He then offered them a treat of their choices such as a marshmallow or Oreo.  He told the children he would be back in 15 minutes with another treat of their choice if they waited and did not eat their treat until he returned. The sample size was 653 children. At the end of the test, the majority ate the marshmallow within the 15 minutes. Roughly a third waited for the second reward.   These results, nonetheless, are not the most interesting part of the test. The most interesting part of the experiment came from the data collected after reconnecting years later with these test.participants. Mischel, along with some help, was able to collect data on 185 of the original test participants. Ninety-four of them provided their S.A.T scores. Professor Mischel found that the people who deferred the immediate treat scored on average 210 points higher on the S.A.T than those who ate the treat in the original experiment. He also found correlations to obesity, response to stress and career success as a whole.

These results should not be surprising.  Delaying immediate gratification with the future in sight results in long-term benefits. Setting down the video game controller and preparing for the S.A.T. will result in higher scores. Choosing to sacrifice eating desert and exercising instead results in weight loss. Saving a portion of your pay check for retirement rather than buying the latest new gadget will create a larger “nest egg” for retirement.
 

Early this month, Robert Cook, who was a successful CEO and investor and a person that I consider one of my mentors, shared this article. The article revealed that most Americans are filled with regret when it comes to financial matters:

           

Fully three in four, in fact, admit they harbor financial regrets, according to a survey of more than 1,000 adults by Bankrate.com.

Their biggest regret: not saving for retirement early enough (nearly one in five Americans put this in the No. 1 spot). What’s more, among those 65 and up, 27% said this was the biggest regret, compared with 17% of those aged 30 to 49. 

Learning to sacrifice certain luxuries now and save pays huge dividends. If a person saves $500 per month starting at age 23, assuming a 7% return on investment, they will have $1,486,659 at the age of 65 despite only saving $246,000. On the other hand, if that same person waits until 35 to start saving the same amount, he or she will only have $612,438 at the age of 65. The person who starts at 35 will have to save over double ($1100) per month to have the same amount of money at retirement.

How is this possible? Compounding. As stated previously, Einstein called compounding the eighth wonder of the world. It is the Rule of 72 at work. The Rule of 72 is a simple rule with which every investor should be very familiar. This general rule tells investors how often their money will double. If you take the number 72 divided by the average rate of return on investment (interest rate), you will get the number of years required for your money to double. For example, if an investor earns and average annual rate of return of 8%, it will take nine years for your initial investment to double. 

Mr. Cook stated the following about the compounding and the Rule of 72:

Individual savers and investors who take the time and make the effort to become familiar with its power will learn to stay the course during periods of market volatility, and they will also come to know that such market events occur regularly over time but don't last all that long.

Accordingly, knowing enough not to panic when markets drop ~10% or so every few years is one fundamental aspect of personal investing success. And knowing how the rule of 72 can help you accumulate lots of assets down the road is also a fundamental aspect of long term oriented successful individual investing.

When Warren Buffet was asked for the single most powerful factor behind his investing success, he responded, “Compound interest.” It is what has made him a billionaire.

Summing Up:
Start saving early and often, buy solid blue chip companies that pay dividends, stay to course, and allow compound interest to work wonders.