Once you have adopted a sound financial lifestyle you can begin the process of accumulating financial wealth. As you begin to invest your savings a second principle comes into play: invest early and often, for two important reasons:
- In order to establish a virtuous habit of regular savings and investment.
- In order to maximize the time over which an investment’s return will compound.
Regular savings and investing
Most of us will be earning our livings from a job, profession, or in self-employment that pays us with an income that arrives in weekly, bi-weekly, or monthly installments.
For many, the best way to save money is to arrange automatic deductions from your paycheck. Many 401(k)s and other employer-provided retirement schemes already offer this convenience.
Similarly, when you invest in an IRA or taxable account, select a fund company able to automatically deduct money from your bank account the day after pay-day.
This concept, described as “paying yourself first,” goes a long way towards establishing and reinforcing reasonable spending habits.
Compounding returns
This example assumes a monthly savings of $500 and a 4% annual return – Need proof? | Vanguard Blog
By beginning to invest at a young age you can reap the advantage of having a long time to compound the return on your investment.
The table to the right shows the clear advantage of beginning to save $500 a month (enough to fund an IRA) at the age of twenty, earning an assumed 4% annual return.
If you start to save for retirement at 20, you will end up with $750,000 by the time you are 65. If you start later at age 40, you will end up with $250,000. That’s a difference of $500,000 and will have quite an impact on your retirement lifestyle.
An alternate way of looking at this advantage is to consider the minimum percentage of your income required to have a reasonable expectation of funding a retirement payout replacing 50% to 70% of your working income over a thirty or forty-year payout period.
The table below, derived from research provided by Dr. Wade Pfau, is from his article Safe Savings Rates: A New Approach to Retirement Planning over the Life Cycle, Journal of Financial Planning, May 2011.
Using a 60/40 equity/fixed portfolio allocation as an example for replacing 70% of income:
- A twenty year old investor can expect to build a thirty year retirement income distribution using an 12.27% lifelong minimum savings rate. A forty-year payout requires a 12.91% minimum savings rate.
- Delaying the start of the investment until the age of thirty raises the minimum savings rate to 23.27% for a thirty-year payout, and to 26.08% for a forty-year payout.
- Delaying the start of investment until the age of forty raises the minimum savings rates to 50.28% and 54.49%.
Next post in the investing basics series: Stock and bond market return and risk
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