February 7, 2006
IF WE SPEND SOME TAX DOLLARS UP FRONT WE WON'T HAVE TO SPEND ANY LATER:
Pour It On, Now (James K. Glassman, 07 Feb 2006, Tech Central Station)
After 30 years of studying finance, I have found few eternal verities, but the most important -- the Golden Rule of Accumulation -- is this: Start early! [...]Let's do the numbers. The average annual return for U.S. large-company stocks (as represented by the Standard & Poor's 500 Index) for the past 80 years has been about 10 percent after transaction expenses but not taxes. Say your goal is to build a nest egg of $1 million by the time you are 55. If you start at age 24 and invest $5,000 a year at an average return of 10 percent annually – through, for example, an index mutual fund or exchange-traded fund (ETF) – then you'll reach your goal. But if wait until you are 34 to start, you'll accumulate only $357,000 by age 55. If you start at age 44, you'll have just $107,000.
Here's a second example, even more dramatic: One investor, call him Ishmael, begins, at age 25, to put $2,000 a year in a low-expense mutual fund with an average return of 10 percent annually. At age 35, he's put $20,000 into the fund. Then, he stops investing entirely. But, of course, the value of Ishmael's holdings keep rising, and, by the time he is 65, he has a portfolio worth $556,000. (We are assuming this is a tax-deferred account like an IRA or 401k).
Now, consider a second investor, Isabel. She, too, invests $2,000 a year at 10 percent, but she waits until age 35 to start. She keeps investing for a full 30 years -- a total of $60,000 out of her pocket. At age 65, Isabel's got just $329,000.
In other words, those extra 10 years (between ages 25 and 35) produce 70 percent more money for Ishmael at retirement time, even though Isabel's out-of-pocket investment is three times greater.
How can this be true? The answer lies in compounding, the fact that interest increases the value of interest as well as the value of principal. If you earn 5 percent on $1,000, then, after a year, you'll have $1,050. After two years, you'll have, not $1,100 but $1,102.50.
As time passes, the power of compounding accelerates dramatically. Imagine that when your daughter is born, you give her a one-time-only gift of $10,000 worth of stock. Assume that the stock appreciates at 10 percent annually, on average. On her tenth birthday, your daughter's stock account will be worth $26,000 (I am rounding up to the nearest thousand in all cases); that is, it will grow in value in that first decade by $16,000. But over the second decade, her account grows by $41,000; over the next, by $107,000; over the next, by $278,000. If the account were earning simple interest of 10 percent on the principal, without compounding, then growth would be a mere $10,000 per decade.
One other important fact about compounding is that a small increase in the rate of return you achieve can have a huge impact over time. In the case of a gift to your newborn daughter, if her portfolio returns 10 percent, then $10,000 grows to $4.5 million by the time she is 65. But if her portfolio returns 8 percent, then it grows to only $1.4 million. If it returns 5 percent, it grows to a mere $227,000. In other words, half the rate of return produces an account that's less than one-twentieth the size.
But enough numbers! If you're a young person, all you need to know is that you must start early.
Thus the genius of mandatory/universal HSAs & personal retirement accounts, which would have you begin saving thousands per year at birth. Even better would be to start everyone off with that $10k deposit -- and/or use Paul O'Neill's plan -- which, combined with means-testing at retirement, would virtually eliminate Medicare and Social security. Posted by Orrin Judd at February 7, 2006 2:14 PM
When I commented some time back that Bush should have named Glassman Commerce Secretary, the regulars here derided the idea. He's smart, has a nice TV personality and is adorably handsome.
Perhaps the ladies would have started paying attention to finance if they had someone cute like Glassman to look at rather than sourpuss old Greespan.
Posted by: erp at February 7, 2006 3:07 PMWay oversimplified. I made over ten times as much at 35 as 25. The discretionary income was probably 100 times as much. It would have been idiotic to begin saving at 25 since I could save more at 35 than in my entire 20s (including compounding) with less pain.
In a person's income cycle during the course of their lifetime, young adults are generally net borrowers with rising income as they start their households and families, middle aged people are generally net savers with more or less steady income (their households are set up), and older people are generally spenders (hopefully of savings) with falling income.
Posted by: Bret at February 7, 2006 5:34 PMCouldn't what?
Posted by: Bret at February 7, 2006 5:44 PMSave more including compounding.
Posted by: oj at February 7, 2006 6:33 PMYour wrong. You don't have access to my financial records so how could you possibly have any basis for such a statement?
Posted by: Bret at February 7, 2006 6:56 PMBecause it's a truism. Personal situations don't matter.
Posted by: oj at February 7, 2006 7:00 PMSay your goal is to build a nest egg of $1 million by the time you are 55. If you start at age 24 and invest $5,000 a year [...] then you'll reach your goal.
(Eyeing recent hospital expenses and fidgeting nervously...)
Posted by: Matt Murphy at February 7, 2006 7:46 PMBret, et. al: there are a plethora of retirement calculators out there, most of 'em are just a bit of javascript that does compound interest calculations. Here's Bloomberg's. set yourself a target of $1M and a range of returns from 4% to 6% (quite conservative) and go to town.
Posted by: joe shropshire at February 7, 2006 8:46 PMMr. Judd;
You are completely wrong. I realize that math isn't your strong suit (heck, it's not even your weak hankerchief), so I never thought I'd see the day when you would elevate some Rationalist theory over practical experience.
I went through the exact situation as Bret, where the amount I could invest in my 30's was so much larger than during my 20's that it was pointless to have saved back then. In fact, I still have the accounts, nicely separated, and despite putting away $2000/year (which made a real difference in my finances), that account barely rises to the level of noise in my net worth. In my thirties, I was investing more every year than the entire compounded net worth of that account and it had no impact on my lifestye.
AOG:
If you put in $2000 a year through your twenties it's close to a million when you retire. If that's insignificant, more power to you, but you're such an aberration as to be meaningless statistically.
Posted by: oj at February 8, 2006 12:07 AMAOG: yah, but -- it got you in the habit of saving, so that when you got to the fat part of your earning curve you already had good habits. Probably the best twenty grand you ever spent. The public-policy goal is to make that good habit more common.
Posted by: joe shropshire at February 8, 2006 1:34 AMOrrin: not quite. If you start at age 25 and contribute $2,000 a year until age 65, here's how it works out to the nearest $100:
Return ........Fund value at age 65
====........===============
4%.............$191000
5%.............$241600
6%.............$309500
7%.............$399300
To reach $1M at 65 given an average 6% return you need to start at 25 and average about $6500 a year.
Posted by: joe shropshire at February 8, 2006 1:50 AMjoe:
Yes. The return is predicated on 10%--the average of the market over the last seventy years--and you won't be retiring at 65 but 68 or even 70.
The example from the story is:
One investor, call him Ishmael, begins, at age 25, to put $2,000 a year in a low-expense mutual fund with an average return of 10 percent annually. At age 35, he's put $20,000 into the fund. Then, he stops investing entirely. But, of course, the value of Ishmael's holdings keep rising, and, by the time he is 65, he has a portfolio worth $556,000. (We are assuming this is a tax-deferred account like an IRA or 401k).
Posted by: oj at February 8, 2006 8:25 AMYes, 6% is conservative. It's basically my own 401k's worst-case projection (what they call the Extended Down Market scenario) which works out to about six and half.
Posted by: joe shropshire at February 8, 2006 12:20 PMWith a medium-risk portfolio.
Posted by: joe shropshire at February 8, 2006 12:20 PMWhy would a young person ever be in a low risk portfolio? What's high risk about just owning the S&P500 for a number of decades?
Posted by: oj at February 8, 2006 12:26 PMPeople don't see it that way. The effort to make savings mandatory will likely succeed, but if this last year's Social Security debate is any indication, you'll have to be very careful about pushing people to take on more risk than they feel comfortable with. If most people felt good about trusting their retirements to the S&P 500 you'd have privatization already.
Posted by: joe shropshire at February 8, 2006 12:34 PMjoe:
People aren't the problem. The Democratic filibuster is.
Posted by: oj at February 8, 2006 12:55 PMMmmm, not so fast. Obstruction didn't hold up against Alito because the polls were for him 2-1. It did against SS reform because those numbers were nearly reversed.
Posted by: joe shropshire at February 8, 2006 1:05 PMPolls have nothing to do with either. Democrats have to maintain the dependency of people on the State or lose power permanently.
Posted by: oj at February 8, 2006 1:20 PMIt's best to save as young as you can. Despite Bret's and AOG's experience, most people will not be able to invest later to compensate for compounded interest. Most people do not make 10 times their salary at 35 as 25.
However, it is also true that most people starting out will not be able to put away $5,000 at 25. $2,000 is more doable, but many things can derail that.
The sad fact is that the people who will most benefit from compound interest are not in the position to take advantage of it. This is a quandry.
Posted by: Chris Durnell at February 8, 2006 1:46 PM