Personal Finance in Your 20s and 30s: Valuing Savings Over Time
Without a doubt, the amazing financial success stories get the headlines. You hear about company founders who make millions — sometimes billions — of dollars. Early investors in stocks such as Apple, Google, and Facebook have made gargantuan returns. Who wouldn’t want to make a return of 100 times, 200 times, or more on his investment?
However, expecting to make such gargantuan returns is a recipe for disappointment and problems. The vast, vast majority of folks I’ve worked with and seen accumulate long-term wealth have done well because they regularly save money and they invest in somewhat riskier assets that produce expected long-term returns well above the rate of inflation.
The difference of continual savings
Okay, so you get that savings is important. How you save is equally important. Continually saving money on a regular basis rather than putting away a one-time lump sum can also generate larger returns.
For example, suppose you earn (after taxes) an extra $1,000 this year at a side job and you decide to save that money. In future years, you decide it’s not worth the bother to do the extra work, so you’re unable to save the money.
Now, compare that situation to one where you reduce your spending so you can save $1,000 per year every year from your employment earnings. In both cases, assume that you put the money in a savings account and earn 3 percent annually (which has been about the long-term average). The table shows an example.
Nest Egg Growth
|Amount Saved||Nest Egg after 40 Years|
|One-time $1,000 saved||$3,260|
|$1,000 saved annually||$75,400|
That’s quite a stunning difference, huh? And that’s just putting away the small amount of $1,000 annually. If you can put away $5,000 or $10,000 annually, then simply multiply the figures by 5 or 10.
The difference a few percentage points on your return makes to your investment
When you save money, you want to try and get higher returns. Bonds, stocks, and other investment vehicles typically produce much better long-term average returns than a savings account or a certificate of deposit (CD), which usually offer a measly 3 percent annual return over the long term. The trade-off with the stocks, bonds, and such is that you must be able to withstand shorter-term declines in those investments’ values.
If you put together a diversified portfolio of stocks and bonds, for example, you should be able to earn about 8 percent per year, on average, over the long term. You won’t, of course, earn that amount every year — some years it will be less and some years it will be more. The following table shows how much you’d have after 40 years if you got a 3 percent annual return versus an 8 percent annual return.
|Investment||3% Annual Return over 40 Years||8% Annual Return over 40 Years|
|One-time $1,000 saved||$3,260||$21,720|
|$1,000 saved annually||$75,400||$259,060|
When you combine regular saving with more-aggressive yet sensible investing, you end up with lots more money. Saving $1,000 yearly and getting just an average 8 percent annual return results in a nest egg of $259,060 in 40 years compared to ending up with just $3,260 if you invest $1,000 one time at a 3 percent return over the same time period. And remember, if you can save more — such as $5,000 or $10,000 annually — you can multiply these numbers by 5 or 10.
With historic annual inflation running at about 3 percent, you’re basically treading water if you’re only earning a 3 percent investment return. In other words, your investments may be worth more, but the cost of other things will have increased as well, so the purchasing power of your money won’t have increased. The goal of long-term investors is to grow the purchasing power of their portfolio, and that’s where investments (such as stocks and bonds) with expected higher returns play a part.