As a college student, I probably drink far too much coffee. I study in coffee shops, socialize with friends in coffee shops, and often meet mentors or co-workers in coffee shops. Because of this, a good portion of my money goes to buying a cup of coffee each day.

Anyone who is familiar with finance and the rule of compounding likely knows where this story is going. That small amount that I'm spending each day — $3, let's say — would grow exponentially if I invested it into a mutual fund.

This concept is now known as the "latte factor," thanks to a tremendously popular book by the financial author David Bach. There's even a website where you can calculate the potential earnings of incremental investments.

Let's go back to my example. If I took the $3 I spend daily on a cup of coffee and put it into a mutual fund that earns an average of 7% a year, I would only have $1,130.20 after one year. That's $1,094.40 and $35.80 interest on the investment.

But I don't plan on living for just one more year. What if I continue to invest $3 a day into the same mutual fund for 60 more years?

I would then have $1,014,313.86. That's $65,664 that I would spend on coffee and $948,649.86 in accumulated interest (still assuming a 7% annual return).

This is not shocking for someone who has studied finance and investing, but there are two important things to remember when looking at the value of incremental investments:

Time does matter

I was recently sitting in a coffee shop (of course), writing an article, when the father of one of my fellow students walked through the door. We began talking about investing and wealth management, and he disclosed some of his own experiences as a self-taught investor.

"I began investing when I was 30," he told me. "But I know I could have much, much more now if I had started when I was 20."

He's exactly right. When you look at compounding, the most important variable is time. The more time that you throw into the equation, the greater your ultimate result will be.

Let's review my earlier example. If I began investing when I turned 40, and put $3 into a 7%-yielding fund for 40 years, I would have $239,382.98. Compare that to the number above, and you'll begin to see why time is such an important factor in compounding. The figure that I just calculated is only 23.6% of what it could have been.

This lesson has been embraced by many investors, but the miracle of compounding has no greater supporter than the billionaire Warren Buffett. Buffett, it turns out, was able to grasp the concept of compounding from an early age. As an article from The Wall Street Journal notes:

From the earliest age, Mr. Buffett has understood that building wealth depends not only on how much your money grows, but also on how long it grows.

Around the age of 10, he read a book about how to make $1,000 and intuitively grasped the importance of time. In five years, $1,000 earning 10% would be worth more than $1,600; 10 years of 10% growth would turn it into nearly $2,600; in 25 years, it would amount to more than $10,800; in 50 years, it would compound to almost $117,400.

If these numbers don't surprise you, then you're either good at math or haven't been reading closely. The phenomenon of compounding should inspire you to invest early and invest often.

We all have our own cups of coffee

You might be thinking that you don't have the resources or the need to invest right now. Unlike me, you might abhor coffee and never buy it. But even if you do not buy a cup of coffee per day, you're probably putting small amounts of money somewhere at regular intervals.

Do you have Netflix? Do you use Spotify? Do you use Amazon Prime? Do you regularly get haircuts from a barber or at a salon? Do you buy a pack of gum every other week at the grocery store? Those are all relatively small amounts of money that are allocated for a good or service each month.

We all have our own version of the latte effect. Whether it's a cable subscription, a music service, or going out to restaurants routinely, we are always spending money that will not be compounded.

Returning briefly to Warren Buffett. As the article continues:

His friends and family regularly heard the young Mr. Buffett mutter things like "Do I really want to spend $300,000 for this haircut?" or "I'm not sure I want to blow $500,000 that way" when pondering whether to spend a few bucks. To him, a few dollars spent that day were hundreds of thousands of dollars forgone in the future because they couldn't compound.

Trade-offs are ubiquitous. We are constantly making decisions on where and how we will spend our money. Some goods are truly necessary and valuable; other goods are not. What is important is that we weed out the areas where we don't truly need to be spending our money.

Warren Buffett was able to think that way, and he now has a net worth of over $80 billion. So what's stopping you?

This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.

© Aaron Schnoor 2020