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Start Retirement Savings Early

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Nest EggsYou’ve probably heard that your most valuable asset is time. For new graduates, that line actually refers to two different ideas, both of which are critically important to understand. The first idea is that with few entanglements and draws on your time (mainly no kids), you can devote more of it to your career and engineer the largest advancements in your career.

The second refers to the power of compounding interest and that’s important to understand with regards to your retirement in forty+ years.

This post is part of Bargaineering’s 2010 New Graduate Guide series where I’ll share my insights and offer my financial guidance to the graduate class of 2010. This post is part of day 1, establishing your financial foundation.

Contribute to a 401(k)

When you start working, your employer may offer you the opportunity to contribute to your retirement through a 401(k) (here’s a primer on retirement investing). They will entice you to do this by offering some sort of matching offer, say 50 cents for every dollar you contribute up to 6% of your salary. You will not find a better deal in the entire world, I guarantee it.

It’s impossible to predict where the stock market will be in a month, a year, or even five years… but in the course of forty years it will surely go up. It’s the classic case of the tortoise and the hare, just be the tortoise and contribute a small percentage of your salary and you will be richly rewarded in retirement.

What to Invest In

Your 401(k) may have a lot of options and that may paralyze you. It’s natural. There are plenty of asset allocation guides but this how to determine your asset allocation summarizes many of those ideas.

The key here is to pick something other than the default, which is usually a money market fund. Just pick something that makes you comfortable, is better than a money market fund, and will let you sleep at night. Emerging markets and small cap will be exciting, but will you be comfortable with the swings? You might logically recognize you can’t touch the money for 40 years, but you may feel compelled to check it regardless.

As a bonus tip, sometime in the next three months you’re going to want to start reading up on Roth IRAs. Don’t worry about them for the next month or two but be sure to read up on it soon.

The key point in all this is that you should start your retirement savings right this second. If you contribute $100 a month, appreciating at 10% a year, is worth over half a million dollars after forty years. Your most valuable asset is time, make sure you use it.

(Photo: roosterfarm)

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29 Responses to “Start Retirement Savings Early”

  1. “You might logically recognize you can’t touch the money for 40 years, but you may feel compelled to check it regardless.”

    You can touch it. With a penalty if withdrawn and not replaced.

    But you MUST touch it. The investments you pick today are not going to be suitable in 40 years.

    And not everyone is as young as you.

    • Jim says:

      Mark, this article is part of the New Graduate Guide series and is aimed at educating people in their late teens and early 20s, so that’s why the language is “speaking” to young people.

      As for the penalty and asset mix, it’s suitable for someone who is just starting to save for retirement. After a year or two, then it’s important to revisit, rebalance, etc. For now, in the rush of starting a job and whatnot, I think this basic advice is suitable.

      • Stacey says:

        Mark, some of us are young, and we appreciate all the advice we can get. :-) (I’m going to share this with my friends, btw.)

        I don’t have kids, so I don’t care about college savings. I don’t have debt, so I don’t care about how to pay down credit cards. There are so many different situations to cover when you write a personal finance blog, and I appreciate the fact that Jim takes some time to reach out to young people once in awhile.

        Besides, the power of compounding works whether you’re 18, 25, or 40! I think the takeaway message should be “start savings as early as possible.” Pick a broad-based index fund, add a bond fun if you’re closer to retirement, and just start stuffing money in that account. Yes, you’ll need to rebalance eventually – but the key is to just get started.

  2. zapeta says:

    The worst investing mistake you can make is not starting early. If you’re just starting a career, get your retirement contributions started right away and refine your asset allocation later.

  3. Craig Ford says:

    When I was in my early 20’s I was fortunate to be forced to decide where some retirement funds had to be invested. That was actually a huge blessing because it forced me to get out and do the necessary research about retirement planning. Had those funds not been available I bet I would have pushed it off for several years.
    As a result, I suggest writing a date on the calendar (within six months) and decide that you will do the necessary research by that date so you can start investing. Otherwise tomorrow will always be the best day to figure out how to get started.

  4. eric says:

    I find that most know to invest in their 401Ks but for sure the biggest concern is WHAT to invest in. A lot of my friends ask me the difference between so and so funds. I’ve seen portfolios that were entire invested in one fund while others had 20 and more overlapping funds.

  5. Saul says:

    An index fund should be fine. It shouldn’t be too daunting to compare the fees since they tend to perform similarly.

  6. kat says:

    I had a lot of loans when I was in college, because I didn’t really get support from my parents. Now that I’m going to graduate school, even more loans are coming. I keep seeing in people’s blogs how they say “Start early, invest in your 401(k)!” or “Save $100 a month and you will start building wealth!”. It is not very practical when 30% of my monthly income goes to student loans. I have been already frugal but not sure what else I can do to save money when I’m in grad school.

    • Stacey says:

      Kat, did you know that your loan payments can be based on your income level? http://studentaid.ed.gov/PORTALSWebApp/students/english/IBRPlan.jsp

      I don’t encourage stretching loans out as long as possible, but this might allow you to start saving for retirement and other goals (a house downpayment? a replacement car?) while you’re paying down your loans. Then as your income rises, you can start tackling BOTH savings and debt goals.

      Good luck! Been there, done that. :-)

  7. javi says:

    Start saving as soon as you can, especially if you have a company match. That is free money you’re missing. I waited 3 years before putting money into my 401k and I feel sad when I look back and see all the money I could have had.

  8. Aarin says:

    Thanks for writing this introductory series.

    I was hoping to get an answer to what seems like a basic question: how exactly does an investment generate a compound return?

    For example, say you purchase 100 shares of an index fund, priced at $50 per share, to max out your ROTH IRA contributions for the year. Let’s assume that at the end of the year, the unit price increases to $55. So for the year, your investment has generated a return of 10%. However, in this case, is the return not merely a paper gain?

    If you make no further contributions for ten years, wouldn’t your return be the difference in the price of the per unit cost when you purchased it ten years ago and the price when you sell it? Since the positive change is based purely on the per unit price and your total shares don’t actually change if you don’t make any additional contributions, how do you get ahead?

    I can see how the math works if you invest in a fund that guarantees a rate of return, say 1% in your checking account. The gain is real and the interest you earn will earn interest…but when it comes to index funds (which is what most people recommend you invest in) how exactly does the math work there?

    When people say that the stock market generated an annual rate of return of 10% over a 30 year period, isn’t that figure just the overall return over that time span? Doesn’t that mean that in some years your investment may have generated a positive return, other years a negative but the end result is a net gain of 10%? How exactly does that compound?

    Aside from any dividends that you may reinvest into the fund, how exactly does your money compound and work for you?

    Sorry for the lengthy question.

    • Jim says:

      You are entirely correct, the reason why they say “annual rate of return” is because that’s the simplest way to understand it. It’s not guaranteed but when you buy a single company, you generally are buying its future cash flows. So if a company expects to generate 20% return on equity (ROE) then you’d expect some of that to be reflected in the stock price, even after accounting for all the other things that affect a stock price.

      You are also correct about it being a paper gain, or an unrealized gain. That, at least for tax purposes, is a good thing. You pay taxes on the guaranteed 1% each year, you don’t pay taxes on paper gains, only when you realize them.

    • DIY Investor says:

      Aarin: Check out my post below. If you had invested $10,000 in the funds comprising that diversified portfolio 20 years ago based on Blackrock’s numbers it would have been worth $47,037 at the end of 2009. This works out to an average annual return of 8.1%.
      In other words, you would have to compound your return at 8.1% per year for 20 years to turn $1 into $47.
      The portfolio’s actual return varied between +27% (best year) and -22% (worst year).

  9. DIY Investor says:

    Where you put your money is important. Blackrock has published sector returns for the 20 years ended 12/31/09. They found that $10,000 in cash grew to $22,446, in Large Cap Value $54,400, and in a diversified portfolio (35% bonds,65% stocks) $47,037.
    Two suggestions: read a book like “How A Second Grader Beats Wall Street” by Allan S. Roth or sit with an advisor for 1 hour, pay him or her $150 and have him or her look over your choices and make a recommendation. Be prepared to answer some risk tolerance questions.

  10. Bern says:

    We actually cashed out our 401k and started a personal bank using whole life insurance policies. It allows us to earn back the interest that we would otherwise pay the bank for large purchases like cars, etc.

    It’s a strategy that banks, corporations, and the wealthy use. It’s a strategy that’s provided greater returns than when I did invest in my company’s 401k.

    • DIY Investor says:

      You cashed out your 401k? Did you pay a 10% penalty? Did your company offer a match? What kind of return do you expect after all fees?

      • Bern says:

        Yes, I paid a penalty and yes my employer paid a match.

        After a good amount of studying, I learned that my 401k retirement plan did not fit well within my financial blueprint.

        I use my policies to create my own personal bank. It’s the Infinite Banking Concept. I finance things through my own bank and earn the interest I would otherwise pay to another bank.

        But beside this strategy, my policies offer me guarantees, full control and flexibility, liquidity, and tax free access to all the gains. Things that a 401k doesn’t offer…

  11. Aarin says:

    Jim & DIY -

    Thanks for the replies.

    Maybe it is the terminology that is throwing me off, but is the term “compounded return” the most appropriate way to describe your return.

    DIY, in your example where you have an initial investment of $10,000 growing to $47,037 in twenty years, is that necessarily compounding at work?

    What I mean is that the difference between the two figures over twenty years is what the various stocks in your portfolio are now worth. Because your total number of shares don’t actually change…it was the per share prices that did…isn’t the difference of $37,037 what your portfolio merely what your collection of stocks are now worth, collectively?

    In my mind when something “compounds” it is gradually growing and the positive interest that is generated generates additional interest. Again, maybe it is just the terminology that is throwing me off, but I don’t see how a difference in how much a stock is worth in twenty years as opposed to what you paid for it today translates into the value of the dollar compounding.

    Unless that is the industry standard terminology used to explain the total change, over a span of time…which I think is how you described it, DIY.

  12. DIY Investor says:

    Aarin –
    Think of it like this – if you put $10,000 in the bank and earned 8.1% a year, compounded annually, at the end of 20 years you would have an account valued at $47,037.
    If you had invested in the stock portfolio you would have the same value for your account – $47,037.
    In both instances you are in the same situation because you can cash in the accounts and have the same amount.
    The reason it is expressed like this is to make comparisons easy. If someone asked whether it would have been better to have money invested at 7% compounded over the past 20 years or to have invested in the stock portfolio the answer is easy. The stock portfolio earned the equivalent of 8.1%/year compounded.
    To calculate the stock return do (47,037/10,000)^.05,,,where the .05 = 1/20.

  13. Aarin says:

    DIY -

    Thanks for being patient with your answers.

    The math makes sense – whether you invest in a bank or in stocks, if you earn 8.1% compounded annually in either account, the end sum will be the same.

    After reading over your responses it looks like that is just the easiest way of describing your exact annualized return rate over a period of time, to be able to make comparisons more easily.

    I think what is throwing me off is when an example is presented where, if you wait “X” years to invest, if your money grows at “Y”, compounded yearly, your difference will be “Z”.

    Wouldn’t this only be the case if the rate of return stayed the same during the entire time and isn’t that a very unlikely scenario…that money you use to invest in year 1 will generate the same return as the money you invest in year 10?

    For the example you provided before, wouldn’t that only be the case if you invested $500 per year ($10,000/20) and at the end of year 20 your investment is now worth $47,037? If the rate of return is so unpredictable, how can one possible make this claim?

    Is it just looking from a historical perspective (ie: stocks over “W” time span have generated “X%”…so if you wait “Y” years, you’ll be losing out on “Z” dollars?

    One more question –

    Say you want to invest in the S&P 500 through an index fund (ie: SPY) and purchase 200 shares at $50 each. If you don’t make any additional purchases, at the end of 20 years if your portfolio is worth $47,037, that means that the per unit price has increased from $50 to $235.19 each and over the span of 20 years, your annualized return rate is 8.1%…correct? (Assuming no reinvestment of dividends)

    If this is the case, does that mean that the only way you can earn that kind of return is to expect the S&P 500 to eventually grow from $50 per share to $235.19, with ups and downs in-between, but gradually sloping upwards?

    Again, sorry for the long post and for the continued patience of trying to explain such a simple concept.

    • DIY Investor says:

      Last part of the question first. The dividend is assumed to be reinvested in the security. this of course is part of the reason for the nice long term results in stocks. You buy a stock at $10/share that pays a $0.25 dividend and if 10 years later it is a dividend of $1 your yield at cost is really high.
      For the first part, it doesn’t have to have the same return each year. If the average annualized return over 4 years is 9.2%, for example, the first year return could -5.3%, the second year +12.8% etc. What is important is that your portfolio has grown to exactly the same value it would have attained if it had earned 9.2% every single year.
      In terms of the $10,000, that is the amount you start with. It isn’t $500/year.

      • Aarin says:

        Thanks for the clarification.

        Back to the question about examples stating waiting “X” years to invest can cost you “Y” dollars if the rate of return is “Z”

        In a hypothetical situation, someone can say: traditionally the market has generated an annual rate of return of 10%, so if you wait 10 years to invest, you’ll cost yourself ten years of compounding at 10%.

        Is a statement like that is based on the premise that over the long run, the average annualized return has been proven to be 10% …so in theory, if you extend the years out another ten years, the annual rate should remain 10%, even though the actual return per individual year may be radically different?

        • DIY Investor says:

          Here’s the deal: because of compound returns investing early can make a big difference. If the market returned 5% this year and 6% next year and you started with $100 then you would have $105 at the end of year 1 and $105(1.06) at the end of year 2 etc. If you are putting in $100 per period the sequence of returns matters. If you start with a fixed amount ($10,000, say) the sequence doesn’t matter.
          In looking ahead no guarantees can be made. In fact, the last 10 years have been bad for stocks – mainly because they started from very high levels.

          • Aarin says:

            DIY -

            Thanks for taking the time to answer my questions – it has been extremely helpful.

            I had one more general question that doesn’t necessarily fall in line with the previous questions but was wondering if you had an answer to:

            Index funds and ETFs of the same family are meant to track the same index, correct? For example, Vanguard’s Emerging Market Index Fund (VEIEX) has an equivalent ETF (VWO).

            Can you explain to me why there is a big difference in price between the two? VEIEX, as of 05/24 is valued at $23.41 while VWO is at $37.01.

            If I am contributing to an IRA and have a limit of $5,000 per year, the difference $13.60 of would result in almost 80 less shares. So aside from a 3k minimum initial investment, the inability to trade the fund as a stock like an ETF and some fees that only apply to the Index Fund, why would I give up the ability to purchase a noticeable number of shares, in an account that has a yearly cap, when the total number of shares impacts your total portfolio performance increase as well as your dividends?

            Thanks

          • DIY Investor says:

            Aarin-
            Don’t worry so much about the price and the number of shares. I don’t know if you are familiar with stock splits but when a stock splits you have twice as many shares but nothing really of substance has changed. It is similar here. When you establish an index fund you can do it at a tenth (example SPY) or some other proportion. It doesn’t matter.
            What does matter is the return! The mutual fund and the index will have similar returns. One difference is the expense ratios of the two which you should always check. If you are trying to decide which to buy go to the issuer website and compare characteristics etc. Morningstar is also worthwhile.
            In terms of shares I always round down to lowest round number. For example, I wouldn’t buy 83 shares. Instead I would buy 80 shares. If you are putting in a certain amount of money of course this will be a moot point. In fact, with funds you get fractional shares.
            I hope this helps.

  14. The stock market has corrected, there are under-priced bargains on the table at the minute. I am talking about quality stocks and well diversified etf funds that will outperform as the market lifts. This is where those looking to boost their retirement incomes should invest part of their savings.

  15. Another drop in the market last night due to ‘panicked sellers’. Several etfs now screaming buys. This is the opportunity that reirement accounts will be thankful for. Take the opportunity while its here.

  16. jsbrendog says:

    the target date funds are especially good for young people who know nothing about investing. It allows them to just get it started, which is the msot important part, and then be contributing while they a) learn mroe aout it and down the road start investing in inividual funds themselves or b) learn mroe aout it and decide that they are good with the target date fund.

    the only problem is when you don’t reasearch it and learn about it in order to make an informed decision.


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