Every penny saved is a penny earned, right?
Well, that’s not really true. At least, not long-term anyway. Save money now, and you’re allowing yourself to make more money in the future.
- Save now, swim in money later!
I thought of this as I had a recent discussion with somebody just out of college, which means that person was a number of years younger than me by the way. Anyway, he was actually talking about saving money, which – as you could imagine – impressed me. Given his age, and his talk about saving, I thought about what a great opportunity this guy would have to grow net worth just if he applied sound personal finance principles right away.
At the age of 22, a person decided to think of opportunity costs, cut back on some extraneous expenses, and save an extra $1,000. He (or she) could do this by driving a less expensive car, cutting back on going out, living with Mom and Dad, or realizing that travel is overrated and often simply expensive entertainment (for many of us anyway). There are many ways one could save $1,000.
Let’s assume he managed to make such decisions to allow for an extra $1,000 to be saved each year for just 4 years from ages 22 to 25. Then, then the money was invested at a 7% annual rate of return (after accounting for inflation, considering the time value of money) and compounded/held until age 65.
The net result? He would have over $66,000 accumulated by the age of 65. Just for those annual $1,000 investments for 4 years, from ages 22-25. Not bad!
If the rate of return was improved, that figure could be even higher. Let’s say he took those 4 years of $1,000 investments, and hit it out of the park by earning a 10% rate of return adjusted for inflation. He would then have an extra $210,000 in today’s purchasing power by age 65, just for making a few smart decisions when younger.
While it’s clearly much, much better to start when young, those getting a late start can still benefit. If somebody starts at age 42 with these 4 years of $1,000 investments, and holds until 65, that 10% rate of return means over $31,000 by 65. If you multiply this out, one can see the value of compounding based on time and rate of return.
Again, it’s just a matter of making a few adjustments for a lot of people, deciphering wants versus needs, and having the discipline to follow through on a few adjustments. Really, the possibilities are exciting when you think about it!
My Questions for You
Do you ever think about trying to set aside incremental smaller amounts like this, and squirreling it away for the long-term?
Do you apply the opportunity cost concept, when thinking about spending money? In other words, if money is spent today, what it could become in the future if otherwise invested.
Have you thought about how powerful time and rate of return can be in terms of impacting your future net worth?
The time value of money is huge. The more you save at a young age, the better off you will be later.
Marie – yep, time can be a real asset in the quest for wealth growth.
I like this example, and have heard it before – if you invest x today you will have y in 40 years based on z return. Tho I do have a few issues with it’s oversimplification…
It assumes a low rate of inflation, but based on what the Fed has done in recent years I would venture to say inflation is much higher than the “official” amount, and could get even higher when Bernanke’s damage is all done. This could wipe out a lot of the return.
It also assumes the stock market will continue to go up at an expected rate over time. In reality it could easily be overvalued and drop at any time (sure the economy could be re-inflated by the Fed, but it gets wiped out through inflation then).
Overall I have to agree with you that stocking away small amounts is generally a good thing (who would disagree with that?) but I think the actual returns will be a lot less impressive than what most people think.
DC – I hope those historical returns can hold, wouldn’t want things much different in the opposite direction! That would put a damper on things, though saving money now is still a good idea even if that happened, as you noted.
I never think about the opportunity cost in the very long term, I think of it in the intermediate term. If I invest that $1,000 in [education, real estate, equity markets], where will I be in 5 years. What doors could that open?
Eric – I like how you refer to education as another wealth-creating investment. It sure can be just that in some cases.
I typically think of opportunity cost in the more near term, mainly because there are so many things I’d like to replace in the house. If I didnt spend 10 on chipotle, I’d could spend it on a new dryer, and so forth. Occasionally, I think about the long term investment choices, but honestly not all that much.
Jeff – LOL I know what you mean, I think of things that way too (if I didn’t spend 10 eating lunch out, etc).
We are constantly trying to balance ourselves. $5000 a year into each Roth IRA for our future along with mortgage payoff money for our present sanity. It’s actually hard to determine what’s right for us exactly since we hate debt as much as we love saving for retirement…
Great discussion! A lot of people may not yet realize that if you delay saving money for retirement, the more money you need to set aside to keep your sanity after retirement.