The Right Way To Save And Invest To Build Wealth
Ask Real Deal Retirement
I’m just starting out in my career and have managed to save up $1,500 dollars so far. I want to start saving more and invest it in a way that can best put the benefits of compounding investing to work for me. Any suggestions?
Your question shows that you’re already on the right track, by which I mean that you seem to get the fact that to build wealth and achieve financial security you need to both save and invest. That may sound like an obvious notion—and it is—but nonetheless too many people put far too much emphasis on the investing part and tend to neglect the saving part.
In fact, I’d go so far as to say that while saving and investing are partners in building wealth, saving is the more important of the two. It’s possible to accumulate wealth solely by saving (although I don’t recommend you limit yourself to saving alone). But you can’t generate wealth just by investing, as without savings you’d have nothing to invest. And even the savviest investing in the world can only do so much if you’re not saving regularly.
Here’s an example. Let’s say that you invest your $1,500 in a diversified portfolio of funds that earns 6% a year. And let’s further assume that to get the benefits of compounding—i.e., earning interest on interest or a return on your investment returns—that you reinvest all your investment earnings in additional fund shares (something pretty much all funds will do for you automatically if you choose).
After 40 years, your $1,500 would have grown to just over $15,400. Not bad, but hardly enough to set you up for life or to fund a secure retirement.
But look what happens when you continually throw more savings into the pot. If, for example, each year you save an additional $1,500 and invest that alongside your original $1,500 and continue reinvesting all your investment gains, after 40 years you would have just over $246,000. Now we’re beginning to talk about real money.
What you might find particularly interesting about this second scenario of saving and then investing $1,500 a year is that by the 12th year the amount you’re adding to your stash through re-invested earnings actually exceeds the $1,500 a year you’re saving. Indeed, by the end of that 40-year period, your re-invested investment earnings each year would total nearly 10 times the $1,500 in savings you’re kicking in. That shows just how much compounding can work for you when you combine regular saving with investing.
But you can probably do even better. After all, when you’re just starting out, scraping together $1,500 a year to save may be a challenge. But as you advance in your career and earn more, you ideally should be able to save more without crimping your lifestyle too badly. And by increasing the amount you save as your salary increases, you can really start to see the bucks add up.
Let’s take the case of someone who’s 25, earns $35,000 a year and receives 2% annual pay raises. If that 25-year-old saves 10% of salary each year and earns a 6% annual return on that money, by age 65 that person would have just over $725,000. Push that savings rate to 15%—the target recommended by many retirement experts—and our hypothetical 25-year-old’s stash would crack the $1 million mark.
I’m not suggesting you can duplicate these figures exactly. Neither I nor anyone else can precisely predict what returns the financial markets will deliver over the next 30 to 40 years (although many investment firms believe returns will come in lower over the next decade or so than in the past). More importantly, even the most committed savers may experience bouts of unemployment, health problems or financial setbacks that knock them off their savings regimen.
The point, though, is that if you really want to build wealth and create financial security for yourself, you need to save diligently and invest sensibly. And you should start ASAP, as even a few years of procrastination can significantly reduce the size of your savings balance. (For example, if the 25-year-old above waits until age 30 to start saving 15% a year, his age-65 account balance would shrink by more than 20%.)
So as a practical matter how do you do this? There’s no shortage of ways to save money. Some people use budgeting software to track their spending in dozens of categories (lattes, clothing, telecom fees, dining out, etc.) to find places to reduce outlays and squeeze out some savings. Others like to use savings apps that invest your spare change or rely on algorithms that periodically shift money into savings supposedly without you noticing it. If such systems work for you, fine.
Personally, I prefer a simple system of setting aside a certain percentage of salary upfront—ideally 15%, but you can start with a lower figure and gradually increase it—and having that amount directly deducted from your paycheck and put into a 401(k) or transferred from your checking account to a mutual fund account. I like this arrangement because it makes saving automatic, ensuring that the money you intend to save actually gets saved, not spent (which is usually the more likely outcome). But whatever method works for you is fine, as long as you actually end up saving on a regular basis.
I also prefer simplicity when it comes to investing. Ignore all the chatter from investing pundits about shifting your money from one market sector to another to maximize gains and don’t fall for the pitch that you’ve got to invest in every new whiz-bang investment Wall Street churns out in order to earn competitive returns. All you need is a simple mix of low-cost stock and bond funds, preferably index funds or ETFs. Index funds and ETFs typically only a small fraction of the fees that actively managed funds do, which is important as research shows that funds with lower fees tend to outperform their high-fee counterparts.
You can get by with just a total U.S. stock market fund and a total U.S. bond market fund, but for additional diversification you might consider adding a total international stock fund. If you really want to go the extra mile, you can also throw in a total international bond fund. You can find such low-cost stock and bond funds at a variety of investment firms, including Fidelity, Schwab and Vanguard to name a few.
Since you’re young, you’ll probably want to tilt your holdings more toward stocks than bonds, as stocks have historically generated much higher returns. That said, stocks can go through some pretty severe downturns, so you’ll want to make sure you can handle the ups and downs without bailing out of stocks when their prices are depressed. You can get a sense of how to divvy up your holdings between stocks and bonds by going to Vanguard’s risk tolerance-asset allocation tool.
If you’re not sure that you’re up to the task of putting together a portfolio on your own, you can always invest in a target-date retirement fund, a type of fund that gives you a ready-made mix of stocks and bonds appropriate for your age.
One more thing: I get the feeling that you’re anxious to start investing that $1,500 you saved up. And such enthusiasm is fine, but before you start investing in stock and bond funds, you should first set aside three to six months’ worth of living expenses in a very secure place such as an FDIC-insured savings or money-market account. Yes, the returns will be abysmal on that money. But the idea is to have a stash you can fall back on in the event of an emergency or to cover a large unexpected expense without having to tap into your stock and bond investments, which you’ll want to hold for the long term.
So ramp up your saving effort, and once you’ve established that emergency fund, start putting together a mix of low-cost stock and bond funds or ETFs. Then stand back and let the power of compounding do its work. (9/25/17)
Walter Updegrave is the editor of RealDealRetirement.com. If you have a question you would like Walter to answer online, send it to him at email@example.com. Follow Walter on Twitter at @RealDealRetire.