1. Contributions vs. Growth
Submitted by Larry Frank Sr. on Wed, 08/14/2013 - 9:00am
The two ways to grow your portfolio are through contributing your own
savings and market returns. In the latter stages of life, your own
contributions have a much larger impact on your overall savings.
Obviously, saving $6,000 every year is better than saving just $6,000
once. But the contributions that you make earliest in life matter the most.
The longer these funds stay in the market, the more you benefit from the
magic of compounding returns.
Dr. Craig Israelsen crunched some numbers for a Financial
Planning magazine article titled “Best Way to Bulk Up.” He found that for
those younger than age 45, increasing returns has a greater impact than
increasing savings. He cautions, though, that this does not mean the
young can reach their goals by under-saving. No, they should save as
much as they can as early as they can, and avoid the attitude that
today’s wants are more important than later needs.
Israelsen found that if you start saving 6% of a $35,000 salary at age 25,
you have a portfolio worth $1.39 million by age 65 if you get an average
10% return from the markets. If instead you save 10% of your salary and
the market only returns 6%, you reach age 65 with $880,012 in your
portfolio. If you play the long game, returns matter more.
For those older than 45, increasing contributions provides a greater
impact. Starting at age 45, saving 6% with 10% returns brings you
$300,173 by 65. With 6% returns and a 10% savings rate, you reach that
milestone age with $324,344.
What favors the young is that they have time to reach for more risk. With
the long time horizon of a 20-something, your savings have enough years
to recover from a debilitating market crash. Also, the effect of
compounding interest doesn’t kick in until the later years – years only the
young have. The cost of delay essentially means that compounding is
2. limited. Older folks who start saving late don’t have those later years of
compounding because they begin taking money out before interest can
really work for them.
Even though it sounds simple for those under 45 to take on more risk
and reach for more return, remember that returns are not under anyone’s
control. Over the very long term, stocks tend to rise faster than inflation,
but you can just as easily strike out over the course of many years. Since
the dot-com crash of 2000, the inflation-adjusted returns from stocks
is almost nil before taxes and fees. It still beats holding cash under your
mattress, however.
It’s fitting that contributions are more effective later in the game since the
Internal Revenue Service allows those over 50 to make an extra $5,500
in “catch-up” contributions to 401(k)s and other retirement accounts. At
any age, contributions are always under everyone’s control, so
proactively maximize them.
No matter how old you are, save as much as you can toward retirement.
You are sure to thank yourself in the future for making the sacrifice.
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Larry R. Frank Sr., CFP, is a Registered Investment Adviser (California)
in Roseville, Calif. He is the author of the book, Wealth Odyssey. He has
an MBA with a finance concentration and B.S. cum laude in physics with
which he views the world of money dynamically. He has peer-reviewed
research published in the Journal of Financial
Planning. www.blog.BetterFinancialEducation.com.
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Topic:
Investing
Stocks
Retirement Planning