In my opinion, there are two powerful tools in successful financial investment: the market and time. If you are able to predict the movement of the market or influence its ups and downs, you are obviously not going to have any trouble accumulating wealth. I know of only one person who has successfully predicted the big market movements again and again in the US history: Warren Buffett. No one else has come close. So unless you are Warren Buffett, the first tool of financial success is not all that useful to you. Time, however, is even more powerful and readily available.
When I say the power of time, I mean the power of compound interest over time. Let’s say our friend Jenny the high school teacher who lives a very frugal lifestyle decided to put aside $1,000 a month to her retirement. She puts this money in her checking account, which earns negligible interest. If she does this for 30 years during her career, this is the amount of money she has at the end of her career.
After putting away $1,000 a month (or $12k a year) for 30 years, Jenny saved $360,000 during her career. Time is a useful accumulator here, but what if she were to take advantage of compound interest over time?
Wow! Please sign me up for that sexy red curve! If only Jenny had put away $12k a year between age 30 and 60, she would have almost $1.2 million to retire.
Notice how the red curve gets steeper as it progresses in time (move from left to right on the x-axis)? Since the compound interest makes the growth exponential, not only does Jenny’s investment increase over time, but the rate of growth increases over time. What if Jenny delays her retirement until she is 65? How much money do you think she will have by then? Perhaps, you should do a calculation for yourself. Here’s how to use FV function to calculate your net worth (post coming soon).
The final question is where do I find a 7% yearly return for 30 years on my investment? What a great question! Look at this picture over here.
The blue line tracks Dow Jones while the red line tracks S&P500. Let’s say you were 30 years old in 1988, wise enough to put $12k a year into S&P500, and wanted to retire today. Your yearly return would have far exceeded 7% a year (7% is a conservatively estimated market growth long term).
Notice the two major market downturns in 2002 and 2008. (Most readers likely remember these times.) Yes, the market will crash periodically. But the $12k per year Jenny puts aside is earmarked for her retirement. She knows that she can hold her stocks through the financial storms since time is on her side. As she gets closer to retirement, she will need to adjust her asset allocation in her portfolio so that she doesn’t need to worry about a market downshift eating up half of her investment right before her planned retirement.
What if you were so wise that you started investing when you were 20? What if you put the money you made in high school in a Roth 401k and invested in the market when you were 14 years old?
The earlier you invest your money, the more you leverage the power of compound interest, regardless of how much you invest. It’s that simple.
What do you think? Are you a fan of long term passive investment? How much do you think you need to retire comfortably?
In the meantime, take a look at my calculations on how costly your financial advisor is in this post.
A few years ago, I set a goal to read one financial book a year to teach myself a critical set of skills that I didn’t learn in school. I think everyone should do it. I recommend starting with this book. I’ve read it cover to cover three times now. Learning new things every time.