We should invest because saving alone is not enough to reach financial independence (FI). Investing can help us compound our money. In this article, I am going to use a case study to highlight the power of compounding and make an argument for investing. Let’s consider these three individuals and their circumstances.
*10% of median salary assuming the starting salary is $72,000 per year.
** You can check out about VFINX here.
Who do you think will have more money at age 55? You probably know the answer but you may be surprised by the magnitude of difference in returns.
|Ending Value at Age 55||Gain|
This table is one the best arguments that I can make that saving alone is not enough. You should invest a portion of your savings if you want to reach financial independence. The reason I chose to write this article even though these types of cases are discussed commonly in personal finance classes is because I wanted to highlight the lessons that I learnt from this case.
This fact bears repeating. All three have equal savings but James ends up with almost 8 times more money than Ben and Julia. That is an astonishing fact and highlights the power of compounding.
Another feature of compounding that I am a big fan of. It takes James 8 years to get to the first $100K but then the time gets shorter and shorter (5 years for the 2nd $100K, 3.5 years for the 3rd $100K, 2 years for the next $100K and then so on).
A feature of compounding is that your money is earning money. It is like having an extra family member that is contributing towards your family wealth. The assumption here is that all three of them are saving 10% of their salary every year. At age 47, James’s portfolio is earning a higher return than his yearly salary.
Think about the previous lesson for a minute. Here you are, working 40 hours a week, Monday-Friday from 8 AM to 5 PM and on the other hand your money is earning more than what you make in a year without any effort on your part (well, you did make the effort of contributing every year and then had the courage to invest.)
It bears repeating that this process of compounding will only work, if you leave this money alone for 30 years and don’t disturb the clock or try to time the market. This article by Fidelity provides an example of someone who missed the best 5 days in the stock market and how their returns get affected.
In this hypothetical scenario , we assumed that James is able to generate 11% returns every year. In real-life, this rarely happens on a consistent basis and it is not guaranteed. The returns on your portfolio will fluctuate, wildly sometimes, but overall you can expect about 8-11% average annual returns if you just let the money sit there and do nothing (except contributing every year).
My personal results are very similar. The annual return on my 401K for the last nine years since 2012 is 11.71% per year. I started tracking these in 2012 and before then I did not pay attention to what my returns were and where my money is invested (what a huge mistake!).
These are the results of my 401K portfolio where I am not allowed to invest in ETFs and individual stocks. My individual brokerage and IRA account returns are much better where I have more flexibility in choosing investments.
We used 11% returns for James but if we change our assumptions and make the interest rate 10% in our calculations, James will have $1,440,991.93 (short by more than three million dollars).
On the other hand, if we raise the interest rate to 12%, he will have $2,187,703 (beating the 11% number by four million dollars). Why am I bringing this up?
Cost of these investments is really important. Pay attention to the expense ratio of funds where you decide to invest. It should be close to 0%. Sometimes, we see expense ratios of more than 1%, even 2% and although they look like a small number, but even a 1% return either way can mean a difference of hundreds of thousands of dollars over time.
These were just hypothetical examples and we arbitrarily decided to have them contribute for only 30 years and then stop contributing but remember, in real life you don’t have to stop. You can keep contributing until your retirement age (usually 40 years) and you can imagine what that will do to total portfolio value.
We made another assumption, that the amount of their investment will stay the same over 30-40 years. But, in real life, you get raises (hopefully!) so you can increase the contribution every five years or so. Imagine what that will do to your wealth.
I left this lesson for last because I believe this is the most important lesson. Start as early as possible. One of the most important lessons that I drew from this is that you want to start at the earliest possible time.
Remove James’s first 10 years of contributions and he would end up with $577,543 (short by $1.2 million). Remove James last 10 years of contributions and he would still end up with a respectable $1,639,887.
Many times, I talk to people and they keep pushing investing off because they want to wait until they have a sizable sum to invest or they want to settle down or buy a house or get married first.
You can start by investing a small sum such as $50 per month. You don’t have to wait until you have thousands of dollars to invest. The commissions are zero these days so you can start investing at no cost. I know this because I had the same mentality. I did not start investing through my individual brokerage account until age 34.
I can think of a few other lessons but I am going to leave this blank and ask you readers, what other lessons can you think from looking at this case study?
As always, any feedback is welcome and feel free to write comments below.