“It was the best of times, it was the worst of times.” So begins the classic novel, A Tale of Two Cities, by Charles Dickens. But this is not about the French Revolution. It is, however, about time and the critically important role time plays in the financial planning process. Time, if used to your advantage, could be your best financial friend. Fritter it away and time quickly becomes your worst financial enemy. Consider the stories of two hypothetical families, Andy and Andrea Able and their friends Bill and Belinda Baker.
The Ables and the Bakers are all 40 years old. Through a remarkable series of coincidences, they were in the same high school class, went to college together and, today, Andy and Bill work together as sales representatives for a large manufacturer. Andrea and Belinda work together as assistant producers for the local network affiliated TV station. Their families’ income is almost identical. In fact, for all practical purposes the Ables and Bakers are about as alike as two couples can be, except in one area, the Ables are investors and the Bakers are spenders.
The Ables and Bakers recently attended an adult education class together on personal financial planning. The teacher told about the “miracle of compound interest.” They all marveled at the power of compounding. “Imagine, if I can save $1,000 and earn an average 10% on my money, I’ll have almost $11,000 when I retire in 25 years.” said Andrea one night after class. Her husband nodded in agreement. “Yeah,” said Bill, “but who’s got $1,000?” His wife, Belinda, added “We sure don’t!”
That night the Ables resolved to start saving immediately. They resolved to save $100 per month, every month, and let the miracle of compounding take over. The Ables decided that, given their long-term needs and the risk posed by inflation over the long-term, to target a return of 10%. Is this reasonable given today’s conditions?
While past results cannot guarantee future performance, the long-term average compounded return on the stock market (as measured by the S&P 500 and including reinvested dividends) has historically been about 10% per year. In any given year, stock market returns vary widely. However, over long periods of time, there has been comparatively little variation in stock market returns. For our purposes here, we’ll assume an investment in stocks that mirrors the S&P 500 and, for simplicity’s sake, ignore taxes.
That same evening the Bakers resolved to try to get their credit card bills paid off sometime soon. Then they went out to the mall for dinner.
Assume now that 10 years have gone by and the Ables and Bakers are again talking about their money. The Bakers are thrilled because finally, at age 50, they feel that they are in a position to start saving. The Ables, who have saved $100 per month for the last 10 years and have managed to achieve a 10% average return, just don’t have the heart to tell their friends that they have already accumulated almost $20,500. Bill announces, with obvious pride, that he and Belinda are going to start saving $200 per month.
It’s now 15 years later. The Ables and Bakers are all 65 years old, and we find them at Andrea and Belinda’s retirement party. The Ables have continued to save $100 per month for a total of $30,000 over the last 25 years. They have accumulated a retirement nest egg, from this alone, of almost $132,700. The Bakers have also saved. In fact, they have saved $6,000 more over the last 15 years than the Ables did over the whole 25 year period. The Bakers have also managed to achieve a 10% return. Yet, the Baker’s nest egg for retirement is only about $82,900.
Why do the Bakers have about $50,000 less than the Ables? Time. Nothing more, nothing less. The Ables used time wisely and to their advantage. They were patient, consistent investors who let the power of compounding work for them. The Bakers let time take advantage of them. Even though they were saving at twice the rate of the Ables, time became their enemy.
If you have learned how to spend, you can learn how to save. There’s no secret to saving, you simply have to want to do it enough to spend less today to have more tomorrow. The best way to learn to save is to “pay yourself first.” Make the first “bill” you pay every month a bill you send to yourself for an addition to your investments.
There are a variety of ways you can begin saving right now. Many employers offer 401(k) plans that allow employees to save for their own retirement in a regular, systematic and tax advantaged manner. Very conservative savers can also utilize systematic savings programs with U.S. Series EE Savings bonds either at work (if your employer offers the plan) or where you bank. Many investments will take systematic investments of amounts as small as $50 per month.
Copyright (c) 2011 Joe Maas