The first $100,000 is the hardest

“Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t ... pays it.” This famous quotation attributed to Albert Einstein¹ highlights the strength of a key principle of personal finance and investing: making a return on the initial invested amount and on the cumulative return since the initial investment.

The mathematical formula is simple:

Is it really the eighth wonder of the world? If you already have $100,000 in investments, this concept may seem obvious. With a hypothetical annualized return of 5%, you will have accumulated an additional $5,000 in one year, with no extra effort. At the end of 10 years, a little more than $62,000 will have been added to your assets.

But if you’re taking your first steps toward financial independence, at first glance the compound return formula may not seem as wonderful as the famous physicist and Nobel laureate claimed. With an initial investment of $10,000, an additional $500 will be added to the investment after one year and about $6,000 after 10 years, if you achieve a hypothetical annualized return of 5%. The growth is there, but at this point it’s certainly less than spectacular. Thus, we quickly realize that making an effort to save is vital if we’re to achieve financial independence.

The $100,000 milestone is considered the most difficult and takes the most time to achieve, because the two variables in the formula remain minimal. The value of the initial amount is still low and, because you’re just beginning your journey to financial independence, the amount of time is still too short for its exponential effect to be felt.

Your ability to save will probably be the most important variable in your reaching the first $100,000. Assuming annual savings of $10,000, or $833 a month, and a hypothetical annualized return of 5%, it could take you slightly more than eight years to reach $100,000. About 80% of that amount will come from your savings, and 20% will come from compounding.

As you accumulate your second $100,000, on your way to the $200,000 milestone, the contribution of savings becomes less central; in other words, it represents only two-thirds of the assets accumulated as you go from $100,000 to $200,000. This phenomenon will become more striking with each additional $100,000. When you reach $200,000, your hypothetical annualized return will have the same dollar value as the amount saved each year (5% x $200,000 = $10,000)!

The compound return is exponential, so less effort will be required over less time. It would take you slightly more than eight years to accumulate the first $100,000, but slightly less than six additional years to reach the second $100,000. That’s almost 30% less time! And the exponential power of compounding will only accelerate the growth of your assets. As you can see from the chart below, going from $400,000 to $500,000 would take only 3.2 years.

You could say that it’s also mathematical: spend less than you earn and invest the difference. In other words, live below your means. Real life, however, isn’t that simple. There is, of course, the matter of your income. An engineer with a salary of $90,000 may find it easier to save than a student with an income of $20,000. The key is to control your standard of living and spending! 

As your income increases, you may be tempted to spend more – on life’s fundamental projects, such as buying a home or starting a family, or things that make your life more enjoyable or comfortable, such as a new car, an additional digital subscription or more frequent dining-out.

This phenomenon is called lifestyle inflation. To save your first $100,000, you have to learn how to control this type of inflation. It’s largely a matter of lifestyle and spending habits. By working on it early in life, you can not only increase your savings rate faster but also develop healthy spending habits for the rest of your life. 

Investor Charlie Munger, Warren Buffett’s main partner, summed it up simply in, shall we say, a colorful way:

“The first $100,000 is a b—, but you gotta do it. I don’t care what you have to do— if it means walking everywhere and not eating anything that wasn’t purchased with a coupon, find a way to get your hands on $100,000. After that, you can ease off the gas a little bit.”²

Staying away from cars, taking advantage of discounts and cancelling subscriptions are certainly effective ways to save, but to maintain your savings habits and lifestyle over time, you may want to revisit the basics of personal finance to create an effective system.

1. Draw up a budget: Having an overview of your income and expenses allows you to better target your real needs and the savings you can put aside. Compile your last few months of expenses and take a hard look at them.
2. Set ambitious but realistic goals: Your budget will give you a better idea of your real savings capacity. You can then set short-, medium- and long-term goals accordingly.
3. Pay yourself first: Rather than saving what’s left after your spending, spend what’s left after you’ve saved. In other words, budget your savings, then automate your contributions with every pay cheque. Increase your savings as your income goes up.
4. Get advice: Saving and investing effectively require financial literacy. Having access to support and advice can be a valuable asset.