Saturday, October 24, 2009

Time of savings is important!

When thinking about investing, many people think that returns are the most important number involved. The thought process goes that if you save a little, but get a huge return on that money, you will be set. Unfortunately, while it is popular to expect a huge return, this unfounded optimism can lead you down a road with a less favorable result. The solution to this, while a simple one, may not be the most popular.

If you dedicate more of your income to savings, over a long period of time you will have a good outcome even with a lower return. This should be apparent with any compound interest calculator, as the amount put in as time goes on usually goes up. Many individuals are of the mindset that "I will start saving in ten years, when I have a family." "Ten years won't even make a difference, I've got more important things to do with my money." Obviously these statements vary from person to person, as does the time period, but the point of this is clear. If you start saving earlier, you will come out ahead. I have illustrated this in previous posts, but the concept of "lost opportunity cost" is a good one to mention again.

If you started a Roth IRA when you got your first job at sixteen (I wish!) and contributed $5,000 per year until you retired at age 65, you would end up with around 1.5 million dollars, at a rate of return of 6%. This example is meant to highlight the importance of starting early, but would hard to start at that amount, especially at sixteen. Here's an idea if you ever have the chance to pass this on, I offered to match my wife's little brother's Roth contributions when he gets his first job. He's not old enough yet, but his eyes still lit up!

Now if we bump the start age up to 26 and use the same numbers, minus the extra 10 years of compounding, we get a much different number. The power is in the extra years to compound, as you end up with $817,000 or so without the extra 10 years.

If you started earlier, even though it would have been difficult to do, you would have ended up with almost double the money.

This is obviously not what most people want to hear, and also where many people (including myself before I started learning more) go wrong! It is far easier to save a bit more money and get the market return through index funds instead of chasing returns in individual stocks or actively managed mutual funds. In fact, if you stop chasing returns and just stick to a basic plan for your investments, you will be much less stressed out too!

1 comment:

  1. Makes sense! Save more (the earlier the better) and you'll be better off in the long run.

    I wish everyone our age understood this, why would you wait to save?? It doesn't make sense, save earlier and you'll have more money (insert "duh" here).