Tuesday, January 15, 2013

How Important is starting early?

For those aiming for a traditional retirement age of 65, starting early is their best friend.  If you ask people how much they need to retire most will answer "$1 million".  Now I'm not saying that yes you do or do not need that much, it really depends on your expense level and how you're invested. But for the sake of making the calculations easier we'll assume that anyone can retire at 65 if they save up $1 million.

Some other assumptions we'll make are that this is the typical American family which according to 2009 US Census Bureau statistics, brought in $60,088 dollars.  We'll also assume that the inflation is 0% and that their income doesn't change throughout the entire period.  A constant 7% annual return is achieved through investing in broad market index funds.

Let's look at 3 different families.  We'll have one that both members started investing for retirement early and continued on their way after finding each other.  Family two starts a little later thanks to going to college and having to delay saving to focus on education and they had a part time job that covered their expenses with a little bit of play money.  So family two starts at age 28.  The third family starts very late, they never really thought of saving for retirement and never made it a priority.  Before they knew it life had gone by and now they're 38 and really behind the eight-ball.

Full Page View

Thanks to compound interest and the all important time factor, family one had to invest only $2,645.51 per year to reach $1,000,000 since they started so early at 18.  Family two still is in pretty good shape needing to invest $5,415.94 annually to reach that $1 million goal.  Family three however needs to save $11,581.24 each year.

By starting 10 years later than family one, family two had to invest 2.05 times more than family one each year.  Family three is even worse off since they have to invest 4.38 times as much each year as family one.  Even on a total amount invested basis, family one comes out way ahead with only $126,984 invested.  Family two had to invest $205,805 or 1.62 times as much as family one.  And family three is bringing up the rear again.  Since they had 20 less years to invest and compound their returns they had to in $324,275 to reach $1 million by 65.  That's 2.55 times the amount family one had to invest.

How do they fair when compared to their gross income?  Family one has to save a pretty easily attainable 4.40% of their gross income each year.  Family two has to save 9.01% of their gross income each year and family three's rate jumps up to 19.27%.  Family one and two only need to save fairly small chunks of their gross income each year, but I find it hard to believe that most families that don't start saving until they're 38 will be able to quickly adjust their spending habits to where they are now saving almost 20% of their gross income.  It'll at least take a few years because old habits are hard to break and those are pretty significant changes.

Starting early in saving and investing is one of the best things that you can do.  Luckily I started somewhat early around the 24/25 mark but had I seen this when I was 18 I would have started even earlier.

19 comments:

  1. I started saving with my first career job after college. I wish I could go back and start investing money earlier when I worked all those part time jobs through high school and college. Anyways, I think it is the best thing we can teach young ones is to get into the habit of saving a portion of your paycheck starting from your very first paycheck. If the majority of people had this habit established I think we would be a lot wealthier in general as a country.

    ReplyDelete
    Replies
    1. I wish the school system did a better job of teaching the basics. Even just running through some very basic calculations just to show how interest works. I know when I was in high school we didn't have much taught about personal finance and it we learned anything about interest and the like I don't remember it from there. All we had was one project about setting up a food budget or something along those lines. That economics class mainly focused on the very broad macro related issues and then supply/demand.

      I too wish I had started earlier, of course I didn't even have a clue when I was 18 because I'd never even seen it. I really like the Money Pig, I think that's what it's called, to try and teach your kids about saving, investing and giving. There's 3 slots in the piggy bank and %'s of the money you're supposed to put into each slot when you get any. Plus you can teach math with it too.

      Delete
  2. A second point, I think for most people saying they can accumulate 1,000,000 dollars feels like an unrealistic goal. I remember after I was first introduced to the power of compounding and I was so excited saying I was going to become a millionaire. People around me thought I was crazy and that it was impossible. But I knew the math and knew it was actually quite achievable! Unfortunately I think most people feel overwhelmed and don't understand how achievable it actually is.

    ReplyDelete
    Replies
    1. I think the reason it seems so unrealistic to most people is because it's a very large number and they have no clue about the math. $2,650 a year from 18-65 is very easy to attain, especially if you're making the median household income. Once I graduated from college I started thinking about investing and started crunching some numbers, it was then that I realized I could have a very good retirement if I work all the way to 65, then once I got laid off in early 2009 and saw how little I could live on and still have a happy life I started thinking about very early FI. Now I can't wait until I can get to that point.

      Thanks for stopping by!

      Delete
  3. The late you start the greater the percentage of your income that you need to save. Unfortunately, starting early isn't an option for a lot of people. I spent a considerable amount of time in school, so I got stuck starting at 30 or so.

    To compound matters, for all my time in school, we never had any financial education. So I was basically left coping the spending habits of my parents (who were cheap) and then I had to spend considerable time teaching myself the basics of personal finance and investing.

    ReplyDelete
    Replies
    1. The biggest issue is the lack of financial education. I think anyone can find a way to save if they knew how important starting early was. But with the lack of financial education people have to spend their first few years on their own stumbling through learning personal finance and hope they don't dig themselves in too much of a hole.

      I think if you knew how important the time factor is before hand you could have found a way to save a least a little bit before getting out of school. By continuing your school until 30ish, you had to weigh the risks and rewards. Risk starting so late that it'll be very hard to make up for lost time. Reward higher education should lead to a higher paying job which will let you save more to make up for the lost time. Of course, if you aren't taught even the basics you won't have a clue.

      It's very important to do the research on any potential field you want to go in to. I remember a few years back hearing about this girl that went to a private school for college and then did graduate school there too. When it was all said and done she was $200k in debt. She either lacks common sense or never thought about what she was getting into. She wanted to be a social worker. The median national pay is just over $39.5k per year. How are you supposed to pay off that debt when you're making that little?

      Delete
  4. I read an interesting article in the recent past which suggested that parents might do better for their children by funding their retirement at birth instead of funding their college education. The thinking goes that the added years of compounding would do far more for the child by the time they reach middle age than the absence of debt from college. I'm sure there are a lot of variables which could impact the final outcome, but it sounds like an intriguing idea. I'd certainly be interested in seeing what the funds my parents spent on my own education would be worth now if they had invested them in a S&P index fund and left them alone for my future use. With the current account value I'd probably be able to pay off my student debt easily and have a nice cushion left over.

    ReplyDelete
    Replies
    1. *(My hypothetical student debt, of course).

      Delete
    2. Hrmm...that's pretty interesting. I don't have any kids yet, but I've been thinking of how to go about teaching them about money, saving and investing. I like the idea of purchasing stocks in companies they can relate too in their name. Such as Disney and the like and once they get old enough to be able to comprehend the numbers better start going over that with them.

      That's a pretty interesting idea. Investing for their retirement starting when they're born sure sounds like it'd put them much further ahead. $1k invested when their born earning 5% a year would be worth just under $24k by the time their 65. Invest $1k per year until their 18 and they'd have $18.5k on their 18th birthday. If they let that compound until 65 that's $292.6k and doesn't even include anything they saved. That could be a much better way to go. Thanks for giving me and my wife something else to think about.

      Thanks for stopping by!

      Delete
  5. I know very well how important it is to start early. Unfortunately it is not my case and I have to deal with it. My only chance now is to apply income strategies and leverage to overcome this late start disadvantage. It's possible to create enough income with less total value, but it may be risky. But do I have a choice?

    ReplyDelete
    Replies
    1. Martin,

      I wish I'd have started earlier but don't we all. Even if you start late it pays to know what you have to do to reach whatever kind of retirement you're after. You need an actionable plan that you can follow. Considering your other option is do nothing and hope that the government will take care of you, but that's not exactly a life I'm hoping for.

      Thanks for stopping by!

      Delete
    2. He he, exactly. I have never trusted the government and always rely on my own. It would be nice if I get something from SS, but I do not count on it. I may consider it as the cherry on the top of the cake.

      Delete
    3. It'd be nice to get something but I'm not counting on it. If I get anything from SS it's just going to be extra spending or investing money.

      Delete
  6. The power of compounding is amazing. I started saving with my paychecks in high school, put away money for retirement with my internship savings in college, and started investing once I had a full-time job. My portfolio should hit $100,000 by the end of this year and I'm only 25. My hope is that I can stop saving for retirement by in another 5 years or quit working entirely. It doesn't *quite* look like that, but I think it should definitely be possible within the next 10 years. Who says you need to work until you're 65? I vote for 35!

    ReplyDelete
    Replies
    1. Leight,

      It truly is amazing and can work wonders when used in your favor. I wish I had started saving and investing back then but I never did. We did have a stock market game in one of my classes in middle school that got me interested, but without any capital that interest waned. Congrats on getting close to $100k, you're light years ahead of the average 25 year old.

      35 sounds like a great age to retire at. I'm hoping to be able to hit that myself, but if it's between 35 and 40, I'll take it. If I stay with the current job that I have and can keep investing the difference between now and 40 I'll have a great passive income stream. But I think the opportunity to call it quits before then will be too tempting that I won't make it that long. Once I reach FI, my plan is to maybe work one more year and pay cash for a house although a rental property might be something I'm interested in too to try and diversify the income sources. We'll see how things work out when I get closer.

      Thanks for stopping by!

      Delete
    2. Leight, it is a great result. I hope I will be able to get into same territory with my portfolio in next 10 years and quit the rat race too.

      Delete
    3. As long as you can stay focused you'll get there. Life happens so it might not be exactly in 10 years, but even if it's 12 years you're much better off than the majority of people.

      Delete
  7. Time to allow compound interest to occur is your best bet hands down. It allows less risk to be taken where as if you didn't have a lot of time you would have to take risk that patient investors usually avoid.

    ReplyDelete
    Replies
    1. I wish I knew that back when I was in high school because I would have invested at least a little bit of money. That's another great point, if you start earlier and save a good amount your required return goes down which means you can take less risks. I'd hate to be at the point where I'm 50 and have nothing saved for retirement. That would be a very difficult proposition because you can't afford to lose any capital but you need to take more risk to get the potential reward to make up for lost time.

      Thanks for stopping by!

      Delete