Friday, August 28, 2009

Retirement Planning: Start to Invest When You're Young

Is it really important that you start to plan for your retirement early in your career? Does it really make that much difference? Starting a saving and investing program when you're young is likely more important than you think. Take a look at the charts below.

Starting to Save & Invest for Retirement at Age 25 vs. 35 vs. 45



Start saving for retirement when young: compound interest

The solid blue line above shows the results for a hypothetical investor who begins saving and investing $3,600/year at age 25. If that investor earns 8% per year, at age 65 he will have about $1 million (that's actually why I picked $3600). Readers will not be surprised to see that the hypothetical investor who starts investing at age 25 has more money at age 65 than the investors who start at age 35 and 45. However, many readers will be surprised once they fully
understand what the other two lines represent.

The dashed red line shows the results for an investor who waits until age 35 to start. What's remarkable is that this hypothetical investor saved and invested twice as much money each year -- $7,200 year. Even though he is earning the same rate of return (8%), he is unable to catch up because he started 10 years later. Put another way, if he had only invested $3,600/year he would have ended with less than half the nest egg of the investor who started at age 25.

The dotted green line shows the results for an investor who starts investing at age 45. In this case, I had the investor save and invest four times as much each year -- $14,400. As you can see, even that is not enough to overcome the disadvantage of starting so late.

These somewhat surprising results are examples of the magic of compounding.

The Magic of Compound Interest / Returns


You may find the following chart even more enlightening.

Graph showing the magic of compound interest

In the chart above, the solid blue line again shows the results for a hypothetical investor who begins saving and investing $3,600/year at age 25. However, in this case he only invests for 10 years and then never invests another cent. The second investor begins investing that same $3,600/year at age 35 and continues every year 'till age 65. Somewhat surprisingly, even though the first investor never invests a penny for the final three decades, he still ends with a substantially larger nest egg than the late starter.

How can that be? The "secret" is the same in both charts above. At the end of the 10th year, the early starter already has accumulated $52,152. In the 11th year, the return at 8% on that $52,152 is over $4,000. By the time the second investor even starts investing, the $4,000 in returns that the first investor is re-investing from his previous investments is more than the $3,600 that the late starter contributes per year. (Note: it takes longer than 10 years to reach this point if you assume returns less than 8%/year.)

It is also instructive to note that the $1,010,812 accumulated by the first investor in chart one is the sum of the two lines in chart two. Contributions from the first 10 years combined with associated reinvested returns amount to $566,767 at age 65; contributions from the remaining years combined with their associated returns amount to $444,045. The sum of the two is the $1,010,812 earned by investing $3600 for the full four decades.

That's the magic of compounding -- and why the earlier you start your retirement planning, saving and investing the better.

Related Posts

For a better idea of how this applies to your planning, see these easy-to-use graphs:
>What Percent of Your Salary Should You Save For Retirement? (by starting age, with Social Security) 
>:What Percent of Your Salary Should You Save For Retirement? (higher income version)
>What Percent of Your Salary Should You Save For Retirement? (by starting age, w/o Social Security)
My SIMPLE Retirement Savings Calculator
The Easiest Way to Increase Investment Returns: For more on the magic of compounding.
For (much) more detail on compounding, see Wikipedia: Compound Interest.
For more on historical stock market returns, see:
Stock Market Average Annual Returns Since 19xx
Range of Stock Market Returns for 1-100 Years
Range of Stock Market Returns in Dollars: 1-10 Years, 10-100 Years
For lists of other popular posts, see the sidebar to the left or the blog header at the top of the page.
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6 comments:

  1. This comment has been removed by a blog administrator.

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  2. Great use of graphs and examples to show the power of compounding. I'm a mid-twenty something and have already started the snowball and am trying to convince my friends, but they seem to be more interested in expensive leases on new cars and credit card spending. Graphs just aren't enough apparently. Well written post.

    Ryan

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  3. Ryan,
    I commend you for realizing so early that it's a marathon, not a sprint. Maybe some of my retirement planning posts (or maybe even the strategic planning posts) can help you get your message across to your friends.

    Good luck.

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  4. While the 4 . 6 is radically different then what wall street hypes for return I believe your dividens returns are not accurate I think the real rate of turn from 29 - 10 is closer to 7%

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    Replies
    1. ???Sorry, I don't understand your comment. Is it about this post.?

      Delete
  5. This is something worth reviewing to have a bright future.

    ReplyDelete

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