*Each month I contribute a personal finance column to The Rich Life, an online community devoted to the practice of living a rich life with less stuff. Here my inaugural contribution. Find the rest of my series as well as contributions by other women on www.therchlfe.com.
I’ve been pretty smart and really stupid with my money. In 2008, the fall of my senior year of college, I wrote a diatribe in The Daily Texan railing against my university’s lack of personal finance education. I extolled the virtues of saving, investing, and knowing the difference between a 401(k) and Roth IRA. I mocked everyone who hadn’t yet started to save, while I busily invested my money in index funds. And then something funny happened!
I moved to New York, and my dream of maxing out my Roth IRA vanished. Suddenly bills got the best of me – it’s common thought in NYC that paying a full half of your salary to rent is “okay” – and without even realizing it, I spent the next three years slipping out of my savings mentality and into debt. It was slow at first, and because I had some built-up cash, I didn’t feel it. Not until it was too late, and my spending patterns were ingrained.
I wasn’t trying to live the life. I wasn’t spending my time in the Meat Packing area going to new clubs, nor was I indulging myself at expensive restaurants. I was buying all the things that felt normal to me – groceries, the occasional meal out, a gym membership, taxis when I was particularly tired – but it wasn’t until a few years later, $3k in debt, that I realized those “normal” things (plus half my pay in rent) were beyond my means.
So here I am, lecturing this simple calling: Please don’t be stupid.
In this series, I’ll talk about ways to avoid being stupid. These are not get-rich-quick schemes; they are bits of practical advice and ways to understand how to deal with money so you won’t have to worry about money.
In this article, we start with the why: Why is it important to start saving now, pragmatically speaking? In our next few articles we’ll cover how to save by not spending (read: budgeting), and then we’ll explore what to do with all that cash you’re hoarding (invest!).
You should have started saving in high school. Sorry, I know it’s not fun to be told that you’re late. I’m with you. But seriously…
When we talk about saving, the most important factor is actually not how much you save, it’s time. Time is the difference between relying on your social security check at retirement, and not worrying about your social security check. It’s the difference between leaving wealth for your kin and worrying that they’ll have to foot your medical bills.
You’re hearing me talk about retirement for a reason. While we’ll get into the good stuff around saving for shorter-term needs (buying a house!) later, the crux of building financial stability comes in saving for the long term, and doing that now. To understand why, we need to talk about compound returns.
Compound returns happen when your money is invested in a way that earns you a little on top every year. There are a lot of ways to do this – the stock market, high-yield savings accounts, bonds, you name it – but the bottom line is, you are getting a little more cash back at the end of the year than you started with. Compound returns are also the reason it’s important to start saving now. As in, this second.
Consider this example:
Suzie O. started saving $1,000/year right out of college, at age 22. She invested that $1,000 in an index fund that yielded her 10% per year. At the end of year 1, she had $1,100 ($1,000 * 1.10), and she kept that money invested. In year 2 she added another $1,000, so at the end of year 2, her investment was worth $2,310 ((1,100+1,000)*1.10). She continued this savings/investing pattern until age 65, when she had built up a whopping $717,905 in wealth. Great job, Suzie!
Lindsay L. felt like her 20s were for living it up, so she didn’t get on the savings wagon until 10 years later, at age 32. She followed Suzie’s investment strategy – investing $1,000 a year with a 10% return – but when she retired, she had a measly $270,024. Eek!
If both women saved for over 30 years, why did 10 years make such a difference? Poor Lindsay has less than half of Suzie’s wealth!
The answer, of course, is compounding interest, the beauty of which is that growth is exponential.
Remember what an exponential graph looks like? It has that long, slow flat part at the beginning (your first 10 years of saving), but by the end the graph takes an almost vertical shoot up – the way your investment gains will by the time you’ve built up a sizable chunk of wealth. The secret is in getting as many of those tail years in as possible. And how to get more tail years in, without relegating your retirement to age 90? Start saving now.
And in case you’re still not convinced time isn’t the most important factor for accumulating wealth, let’s consider one last example:
Brad thought he had it all figured out. He wasn’t able to save until age 32, just like Lindsay. But Brad knew he had lost a few good years, so he decided to invest double what Suzie and Lindsay did. At age 32, he invested $2,000 a year at a 10% return until he retired at age 65… with a measly $540,049.
Okay, over half a million in savings is not measly, but let’s think about it. Brad put in more money than Suzie – his total investment was $68,000, versus Suzie’s $44,000 – and yet missed her returns by $177,856. What a difference time made!
And there you have it, my friends. It’s not that simple – there are rates of return and risk tolerances and a plethora of ways to grow your money – and yet, it is that simple. To live the rich life – the not-worrying-about-money life – give yourself the gift of time by saving and investing now.