The Power of Saving Early
/By: Drew Hanessian
Happy Spring!
There’s a lot of bad financial news out there - conflict, inflation, stock market volatility, and shortages of everything from avocados to homes. While there’s no doubt that all of these things can have a direct impact on your personal financial situation, we cannot do much to directly change these macroeconomic conditions.
That’s why it’s more important than ever to focus on what we can control, namely, saving and investing. In this article, I’m going to focus on the former and hopefully drive home just how powerful saving early and often can be. If you’re already working with a financial planner, this is likely preaching to the choir, but perhaps you’ll come across a point or two that you can share with someone you care about.
The Eighth Wonder of the World
Like many famous quotes, there’s not much evidence that Albert Einstein ever called compound interest the “eighth wonder of the world.” But its power to create wealth is incredible nonetheless!
If you're filling out a travel bucket-list, the 7 wonders of the world are Machu Picchu (Peru), Chichen Itza (Mexico), the Colosseum (Italy), Petra (Jordan), the Great Wall of China (China), Christ the Redeemer (Brazil), and the Taj Mahal (India).
Whether it’s working against you as persistent credit card or student loan debt, or on your behalf as an investment, interest that builds on itself (compounds) is a force to be reckoned with. I remember sitting in the back of the car as a kid, playing with a calculator and being fascinated by how quickly a number could grow if you assumed a 10% growth rate.
Now, there are several caveats here. First, no one can guarantee a 10% return on investment year after year (though broad stock market indices have returned 8-9% annually over 30-year periods), inflation is not taken into account, and of course, Uncle Sam will want his share in the way of taxes in most cases.
But still, a $5,000 annual investment has turned into $1,000,000!
A total invested sum of $150,000 has more than 6x-ed!
Here it is in a graph for visual learners:
That’s more than enough mulah to visit all the wonders of the world traveling in style.
For a one-time investment compounded annually, the formula is quite simple:
Ending Balance = Starting Balance x (1 + growth rate)^number of years
Ending Balance = $100,000 x (1.10)^30
Ending Balance = $1,744,940
This is the same concept used by James Clear in his Atomic Habits book where he encourages his readers to try to be “1% better every day.”
Let’s demonstrate the effects using a close-to-real-world example.
A fictional married couple, Billie and Joaquin, are both 27-year-old college graduates working in the tech industry. Their combined after-tax income is $250,000 which includes a combination of salary, bonus, and vesting stock grants.
They’re recently married and have just finished paying off their student loans and would like to start investing more seriously. They spend about $150,000 per year and think that will probably be closer to $175,000 when they have kids as they won’t be traveling as much but will need childcare. They would like to walk away from their jobs when they turn 45 and be able to draw $100,000 from their investments annually, which they plan to supplement with income from a mixture of consulting and part-time work.
Using the 4% rule of thumb, we multiply their desired retirement income of $100,000 by 25 to get a lump-sum goal of $2,500,000. They have 18 years to get there…what will it take?
Let’s assume that inflation averages 2.5% (over the long-term!) and their investment returns average 9%. This yields an inflation-adjusted return of 6.34%.
They need to save $6,227 per month or $74,724 per year for the next 18 years to reach their goal.
Luckily, Billie and Joaquin have just enough room in their budget to save this amount (what a coincidence!). Just a couple of additional caveats here - we’re not factoring in any investment expenses which do eat away at returns. However, we also aren’t accounting for any increases in salary or one-time windfalls like bonuses or inheritances.
Now, situations vary and not everyone can, or would, want to achieve this particular goal. But I hope it helps illustrate the power of consistent saving and investing and what can be accomplished in a relatively short period of time.
If you’re inspired to save more but aren’t sure about the next steps, schedule a call with the BPFP team to discuss your options!
