Sunday, May 2, 2010

The Effects of Saving, Investing, and Time

Imagine you are a recent college graduate. Say you find a job that pays the average starting salary for a new graduate, around $50,000 per year and grows at a rate of 5% thereafter. For the sake of simplicity, let's also say that your expenses will run at around $40,000 per year for this first year and will also increase at 5% (this is obviously excluding major events like buying a house or sending your children to college). Imagine that you invest the difference between your salary and your expenses every year in an index fund that produces a return of 8% annually. At this rate, you will accumulate your first million in 22 years, or roughly by the time you turn 44. Your second million will come in 29 years and your fifth will come in 39 years. While this is a very respectable outcome, let's change a few of the factors and see what will happen to your overall wealth.

Saving More

First, let's assume we increase the savings rate. Say you can really live frugally and cut back an extra 10% of your spending per year. Just by doing that and holding everything else equal, your first million will come three years earlier (age 41), and your second and fifth will come four years earlier (age 47 and 57). Cut another 10% and you will be a millionaire by 38, a millionaire twice over by 44, and a millionaire five times over by 53.

Investing Smarter

Now let us say that in addition to saving 40% of your salary, you are able to make some wise individual stock selections that give you a 10% annual return on these savings. Your first million now comes in 15 years (age 37), your second in 20 years (age 42), and your fifth in 28 years (age 50). Now say that you devote most of your portfolio to your shrewd stock selections and are earning 12% each year. This higher return will not only earn you your first million a year sooner, but it will nearly double your wealth by age 65.

Earning More

Finally, let's say that you are able to land a more lucrative job out of college that pays you a 20% bonus each year. If you simply invest this bonus each year along with your normal savings at a rate of 12%, you will be a millionaire in 12 years. By working hard, cutting your expenses, and investing intelligently, you have gone from being a millionaire by 44 to a millionaire by 34. By 44, you will be worth nearly five million and by "retirement age" at 65, you will have accumulated an astounding $65 million.


The lesson here is if you earn an average amount of money out of college, save consistently, and invest passively you can live well, have a million by your forties and many millions by retirement. However, if you can go the extra mile and work to earn a bit more, wisely cut your spending, and make smart (yet simple) investment choices, the power of compounding will make you very wealthy.

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