Compound interest: Powerful ancillary revenue stream

Issue: November 2019

ByDavid B. Mandell, JD, MBA

BySanjeev Bhatia, MD

With health care continuously in flux, physicians of all stripes have often wondered how to maintain their income and achieve financial goals while avoiding burnout. Although ancillary revenue streams have decreased and overhead costs have increased over the years, the single most powerful wealth creator in human history has remained constant: Compound interest.

Orthopedic surgeons too often focus on practice-related revenue streams as a sole means of building wealth without realizing the comparative might of a compounding asset class. In some cases, this leads to significant stress. By not harnessing the power of compound interest, your financial goals will remain handcuffed to the ever-changing practice environment.

Sanjeev Bhatia

David B. Mandell

Herein, we illustrate the magnificent power of compound interest and demonstrate why cultivating this should be the principal focus for wealth creation, particularly among millennial orthopedists and orthopedic residents.

Compounding asset is your best asset

It is said Albert Einstein noted that the most powerful force in the universe is that of compounding. Much like a snowball that grows in size as it rolls down a mountain, a compounding asset gains steam with each passing year as an investor begins to earn interest income on his or her interest income. The result is wealth that grows at an ever-accelerating rate.

In simple terms, three factors determine how an investor’s money will compound: the interest rate earned on any investments (rate of return), the time horizon and the tax rate. As discussed in previous columns, tax-advantaged vehicles like Roth individual retirement accounts, IRAs, 401(k) accounts, cash value life insurance and Section 529 college savings plan accounts may allow tax-free growth and even tax-free access that is in the investor’s favor.

Saving early makes a difference

For newly minted orthopedic surgeons and orthopedic residents, investing even a small amount early on when they are 20 to 30 years old helps them achieve their financial goals faster than most other things they will do during their orthopedic career. For example, consider three orthopedic surgeons who contribute to their Roth IRA, a tax-advantaged retirement vehicle, at different stages of life (Figure 1). Each surgeon earns the same 8% annual return in their Roth IRA. The millennial investor contributes $200 per month to his Roth IRA starting when he is 26 years old, then contributes $1,500 per month starting when he is 33 years old and lands his first job. The middle-aged investor does not contribute anything to her Roth IRA until she is 40 years old, at which time she contributes $1,500 per month until retirement when she is 65 years old. Finally, the late investor contributes $1,500 per month to his Roth IRA starting when he is 47 years old.

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By age 65 years, due to compounding, the millennial investor has amassed $3,130,451 in his Roth IRA, while the others are far behind.

Slow and steady wins the race

The interest rate, or rate of return, is one of the most important determinants in the value of an asset at maturity. Although a high interest rate is always beneficial to wealth creation, it is important to avoid excess risk while optimizing interest rates to minimize devastating losses. One reason the stock market has purportedly been hailed as the greatest wealth generator in the United States is that historically the Standard & Poor’s 500 index, which is a reasonable risk profile asset class, has returned an inflation-adjusted 7% to 8% annual return.

In this example, consider three investors who all contribute the same amount to their Roth IRAs over a 30-year period (Figure 2). The first investor, the non-risk taker, did not care to get any interest beyond a 1% rate. The standard investor follows the S&P 500 and gets an 8% annual return. Finally, the risk taker gets a staggering 15% annual return by investing in high growth stocks and private investments, but sees his portfolio decline by 15% every 4 years due to cyclical downturns in the markets. As the example shows, the standard investor came out far ahead of the other two due to continued growth and avoidance of devasting losses.

Best ancillary revenue stream: Simple investing

Finally, it should be noted that simple investing, begun prudently at an early age, may even trounce many lucrative, practice-related ancillary revenue streams due to tax advantages and the power of compounding (Figure 3). Starting at age 35, the investor surgeon starts contributing $5,000 per month to an S&P 500 fund that yields an 8% return annually and does this until he is 65 years old. In contrast, the non-investor surgeon chooses to put away $5,000 per month when he is 35 years old in a savings account that yields only 1% annually. When he is 40 years old, however, he chooses to become part owner in a lucrative ancillary revenue stream that pays an additional $10,000 per month after taxes until his retirement when he is 65 years old. This too is deposited in the savings account. Interestingly, despite missing out on the lucrative ancillary opportunity and a more basic resultant income, the investor surgeon has $2,224,662 more than his counterpart when they are 65 years old due to the power of compound interest.

Conclusions

Orthopedic surgeons too often focus on practice-related revenue streams as a sole means of building wealth and do not realize the comparative strength of a compounding asset class. As shown in the previous examples, the impressive power of compound interest is the greatest tool for wealth creation, especially for millennial orthopedists and orthopedic residents who start investing at an early age.