Saving, Investing, and Personal Finance – Three Ways To Use Time To Your Advantage
Compounding, your type of distribution plan, and inflation all affect how time will affect your savings. Is time your ally, or your enemy?
Let's start with several compounding examples. Immediately saving and investing at age 25, could generate $3,746,533.17 by age 65. Waiting just 2 years generates $589,705.30 less, and waiting only 8 years generates $1,874,831.22 less under the same assumptions. These numbers are realistic given historical returns, but are not guaranteed. I'll show how the figures were computed later in the article. No matter which assumptions you choose, for every year you wait, you would either have to increase the amount of monthly savings, or find some way to obtain a greater return to reach the same target that time could have provided for you. That is how compounding works. Earlier is always better than later.
Why you would need several million dollars for retirement? Your savings have to provide you with enough income for the rest of your life unless you have some other assets or income. That leads us to the effect of time on your distribution plans.
Death spiral plans assume your savings last a certain number of years by drawing down principal, so savings are shrinking every year. If you assume you'll consume your savings from ages 65 to 85, that is 20 years. Multiplying your annual income by 20 gives the minimal amount you need to have in savings. Unless your returns more than offset withdrawals, your savings decrease. Generally, time works against you.
One alternative to death spiral plans, I call Ascending Helix plans. Your principal generates income, and you live off the income, but never touch your principal. By design, you earn more than is withdrawn, so your principal grows even in retirement. Divide your annual income by reasonable expected rate of return to give the minimum amount you need to save. For example, an annual income of $50,000 divided by .05 (5%) return, gives $1,000,000 in required savings. By withdrawing less than your annual return, your savings increase, generally time works for you.
Inflation is compounding's evil twin. If history is any guide, money could be buying half or less of what it does now in 20 or 40 years due to inflation, only time will tell. Inflation does not stop when you retire. You need to plan for inflation over your lifespan. Inflation causes time to work against you.
Some people ignore time; they assume a safety net or big score will fund their retirement. Safety nets put you at the mercy of others. A big score may never occur. Low rates of return, investment losses, or other items may cause you to miss your target. Financial freedom can arrive through the slow and steady accumulation of resources day after day, year after year. In my opinion, it is smarter to over save than under save, at least until you have exceeded your target.
You have a choice, you can decide to make others rich through your spending, or you can make yourself rich using through saving and investing. Financial planning utilizing the effects of time is a proven personal finance tool; this can be one of many steps in getting to a better point in your financial life. It all starts with understanding your fate is up to you. But, if you're not careful, time will pass, and you will have missed the opportunity time makes available to you.
As I promised, here is how I computed the figures in the first paragraph. I used this Bankrate calculator, but you can use any financial calculator. Simply punch in these numbers.
- Initial Amount: 1.0 (an arbitrary starting $1)
- Monthly Deposit: 1000 (an arbitrary savings rate)
- Annual Interest (Compounded) Pull down Quarterly and enter 8 (Studies vary. I used 8 as an example starting point but it is not a guarantee. Try other values to see the effects.)
- Number of Years 40 (Age 25 to age 65 is 40. Each row represents a year, so subtraction shows the effect of waiting various years.)
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