If you’re young, you may not think you need to open a retirement account. You probably think it’s easier to worry about it five years from now. Or ten. You’re wrong. No matter what your age, now is the time to begin saving for retirement. In The Automatic Millionaire, David Bach writes, “The single biggest investment mistake you can make [is] not using your [retirement] plan and not maxing it out.”
Saving is the key to wealth
If you do not spend less than you earn, and if you do not save the difference, you cannot build the wealth you desire. The rich are not rich because they earn a lot of money; the rich are rich because they save a lot of money.
You may be skeptical — I was once skeptical, too. But over the past three years I’ve read a lot on the subject of wealth-building. Books like Stanley and Danko’s The Millionaire Next Door make it abundantly clear that it’s not a high income that leads to wealth — though obviously a high income does not hurt — but the ability to save. Those who become wealthy do so by spending less than they earn.
If saving is the key to wealth, then time is the hand that turns the key to unlock the door. There is no reliable method to quick riches. There are, however, proven methods to get rich slowly. If you are patient, and if you are disciplined, you can produce a golden nest egg that will hatch later in life.
The power of compounding
The best way to ensure your future financial success is to start saving today.
“The amount of capital you start with is not nearly as important as getting started early,” writes Burton Malkiel in The Random Walk Guide to Investing. “Procrastination is the natural assassin of opportunity. Every year you put off investing makes your ultimate retirement goals more difficult to achieve.”
The secret to getting rich slowly, he says, is the miracle of compound interest. Even modest returns can generate real wealth given enough time and dedication.
On its surface, compounding is innocuous, even boring. “So what if my money earns 3.85% in a high-yield savings account?” you may ask. “What does it matter if it averages 8% annual growth in a mutual fund? Why is it important to start investing now?”
In the short-term, it doesn’t make a huge difference, but on the slow, sure path to wealth, we take the long view. Short-term results are not as important as what will happen over the course of twenty or thirty years.
For example, if 20-year-old Britney makes a one-time $5,000 contribution to her Roth IRA and earns an average 8% annual return, and if she never touches the money, that $5,000 will grow to $160,000 by the time she retires at age 65. But if she waits until she’s my age (39) to make her single investment, that $5,000 would only grow to $40,000. Time is the primary ingredient to the magic that is compounding.
Compounding can be made more powerful through regular investments. It’s great that a single $5,000 IRA contribution can grow to $160,000 in 45 years, but it’s even more exciting to see what happens when Britney makes saving a habit. If she contributes $5,000 annually to her Roth IRA for 45 years, and if she leaves the money to earn an average 8% return, her retirement savings will total over $1.93 million. A golden nest egg indeed! She will have more than eight times the amount she contributed. This is the power of compound returns.
The cost of waiting one year
It’s human nature to procrastinate. “I can start saving next year,” you tell yourself. “I don’t have time to open a Roth IRA — I’ll do it later.” But the costs of delaying are enormous. Even one year makes a difference. Here’s a chart to illustrate the cost of procrastination. Again, we’re using 20-year-old Britney as a basis.
If Britney makes $5,000 annual contributions to her Roth IRA, and she earns an 8% return, she’ll have $1,932,528.09 saved at retirement. But if she waits even five years, her annual contributions would have to increase to nearly $7,500 to save that same amount by age 65. And if she were to wait until she was my age, she’d have to contribute nearly $25,000 a year!
To make compounding work for you:
- Start early. The younger you start, the more time compounding has to work in your favor, and the wealthier you can become. The next best thing to starting early is starting now.
- Make regular investments. Don’t be haphazard. Remain disciplined, and make saving for retirement a priority. Do whatever it takes to maximize your contributions.
- Correct your reports. Get hands on a free copy of your credit report to correct your serious mistakes.
- Be patient. Do not touch the money. Compounding only works if you allow your investment to grow. The results will seem slow at first, but persevere. Most of the magic of compounding returns comes at the very end.
Compounding creates a snowball of money. At first your returns may seem small, but if you’re patient, they’ll become enormous.
This article is part of Financial Literacy Month. Look for a companion guest post on compounding later today.