Ask people the following question: "You have a small worm, .4 inches long, which grows at only 10% each day, how long will it be after 1 year?" Don't use a calculator, answer based on intuition.
On day one the worm will grow by .4 inch. Without compounded growth, after 365 days of .4 inch growth the worm would be 15 inches long. People's answers will include their intuitive adjustments for how much compounding the growth would contribute to the final length. You're likely to get answers ranging from a yard or two, to a couple of miles.
The correct answer would be 7.936 billion miles – more than the distance from the sun, past all the planets, all the way to Pluto … and back!
Most people get this spectacularly wrong because our intuition is very inaccurate when it comes to the effect of compounded growth. Yet, (sadly) most people plan for retirement using similar intuitive assumptions on compounded returns. The (even more sad) reality is that most people miss the incredible potential benefits available to them through the power of compounding, as two (all too familiar) examples will illustrate:
The early bird does indeed catch the worm
At 6% p.a. real growth, every $1 invested at age 23 grows to more than $10 in real terms at age 63. In other words you contribute less than 10% of the final purchasing power of that retirement savings – compounding gives you the other 90% (for "free")!
In comparison, every $1 invested at age 43 grows to just over $3 at age 63 (again in real terms). And any $1 saved at age 53 will only grow to $1.79 by age 63, so for late savings the contribution from compounding is less than the actual savings – a far cry from the 10X increase experienced by the early saver.
Just as with guessing the length of the worm, most people completely misjudge the significant future value of early savings and this is where they get their retirement planning very wrong. They argue that they'll spend early on in their careers, while their incomes are relatively low and that they'll save disproportionately later in life once their incomes have increased. Their intuitive expectation is that a significant increase in savings later in life will offset the much lower savings they are capable of when they are young. Every cent saved at an early age benefits so much more from compounding that for most people it ends up being near impossible to replicate that same potential value through later savings.
In addition, late investments face bigger risk from market timing, since equity returns are volatile and a high entry point could detract meaningfully from short to medium term equity returns (the past ten years in the USA being a good example). But that risk decreases for long investment periods, providing yet another reason to invest early.
Our little .4 inch worm will only grow to Pluto and back if it grows at a compounded rate for long enough. Unnecessary and (especially) early spending are like birds pecking away at our investment harvest. Spend too much early and see if your worm can avoid becoming bird feed…
Where do you want your retirement funds to grow to?