Compound interest

A powerful stream of ancillary income

February 12, 2020

4 minutes to read

Source / Disclosures

Disclosures: Bhatia and Mandell do not report any relevant financial disclosures.


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Sanjeev Bhatia

David B. Mandell, JD, MBA

David B. Mandell

by Sanjeev Bhatia, MD, and David B. Mandell, JD, MBA

With ever-changing healthcare, physicians across all specialties have often wondered how to maintain their income and meet their financial goals while avoiding burnout. Although ancillary income streams have declined and overheads have increased over the years, the single most powerful wealth creator in human history has remained constant: compound interest.

Too often, physicians focus on practice-related income streams as the only way to build wealth without realizing the comparative power of a compound asset class. In some cases, this causes significant stress. By not harnessing the power of compound interest, your financial goals will remain tied to your ever-changing practice environment.

Here, we illustrate the magnificent power of compound interest and demonstrate why cultivating it should be your primary goal for wealth building, especially for young doctors and residents.

Power of compound interest

Albert Einstein once noted that the most powerful force in the universe is that of composition. Much like a snowball that grows larger as it rolls down a mountain, a compound asset grows year after year as you start earning interest income on your interest income. . The result is wealth that grows at an ever faster rate.

Simply put, three factors determine the makeup of your money: the interest rate you earn on your investments (rate of return), the time horizon, and your tax rate. As discussed in previous articles, tax-advantaged vehicles such as Roth IRAs, traditional IRAs, 401 (k) plans, cash value life insurance, and 529 college savings plans can provide tax-exempt growth. ‘tax and sometimes tax-exempt access.

Saving early makes the difference

For young doctors and residents, investing even a small amount in their 20s and 30s helps them reach their financial goals faster than most other things they will do in their medical careers. For example, consider the three physicians who contribute to their Roth IRA (a tax-advantaged retirement vehicle) at different stages of life. Everyone earns the same 8% annual return on their Roth IRA.

An example of three doctors who contribute to their Roth IRAs at different stages of life.  Source: OJM

An example of three doctors who contribute to their Roth IRAs at different stages of life.

Source: OJM

The millennial investor contributes $ 200 per month to his Roth IRA starting at age 26, then pays $ 1,500 per month starting at age 33 when he lands his first job. The middle-aged investor does not pay anything into his Roth IRA until he is 40, after which he contributes $ 1,500 per month until he retires at 65. Finally, the late investor contributes $ 1,500 per month to his Roth IRA starting at age 47. At 65, due to capitalization, the millennial investor has amassed $ 3,130,451 in his Roth IRA while the rest are far behind.

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Slowly but surely, we succeed

The interest rate, or rate of return, is one of the most important determinants of an asset’s value at maturity. While a high interest rate is always beneficial for building wealth, it is important to avoid excessive risk while optimizing interest rates to minimize devastating losses. One of the reasons the stock market has allegedly been hailed as the largest generator of wealth in the United States is that, historically, the Standard & Poor’s (S&P) 500 Index, which is an asset class with a profile of reasonable risk, generated a return of 7% to 8% adjusted for inflation. annual return.

In this second example, consider three investors who all contribute the same amount to their Roth IRA over a 30-year period. The first investor, the non-risk taker, doesn’t care to get anything beyond a 1% rate. The standard investor follows the S&P 500 index and obtains an annual return of 8%. Finally, the risk taker gets a staggering 15% annual return by investing in high growth stocks and private equity, but sees his portfolio fall by 15% every 4 years due to cyclical market reversals.

An example of three investors who contribute the same amount to their Roth IRA over a 30-year period.

An example of three investors who contribute the same amount to their Roth IRA over a 30-year period.

As you can see, the Standard Investor is way ahead of the other two due to continued growth and devastating loss avoidance.

Your best source of ancillary income: a simple investment

Finally, it should be noted that a simple investment, started cautiously from an early age, can even crush many of the lucrative ancillary income sources associated with the practice due to the tax benefits and the power of funding.

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An example showing that a simple investment started early pays off because of the tax advantages and the power of capitalization.

An example showing that a simple investment started early pays off because of the tax advantages and the power of capitalization.

From the age of 35, the investing surgeon begins to contribute $ 5,000 per month to an S&P 500 index fund generating an annual return of 8% and does so until the age of 65. In contrast, the non-investing surgeon chooses to put $ 5,000 per month from age 35 into a savings account that only earns 1% per year. At 40, however, he chooses to become part owner of a lucrative ancillary income stream that pays an additional $ 10,000 per month after tax until he retires at 65. This additional income is also deposited into the savings account. Interestingly, although he missed out on the lucrative ancillary opportunity and resulting more basic income, the investing surgeon has $ 2,224,662 more than his 65-year-old counterpart because of the power of compound interest.

Conclusion

Too often physicians focus on practice-related income streams as the only way to build wealth and fail to realize the comparative strength of a compound asset class.

As these examples show, the awesome power of compound interest is the best wealth building tool, especially for young doctors and residents who start investing at a young age.

Disclosures: Bhatia and Mandell do not report any relevant financial disclosures.


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