Most books about personal finances repeat the same mantra: “max out your retirement accounts every year, and you’ll be able to retire comfortably at 65.” I don’t know about you, but I don’t want to live my entire life preparing for age 65—I don’t have that kind of patience!
Following this rule of thumb has somehow become the accepted mark of financial competence in our society. But in my opinion, it’s simply a terrible rule! In order to explain why, I’d like you to please take out a half sheet of paper and write down your answers to today’s pop quiz. By the way, this quiz will count for 100% of your grade this year 🙂
- True or False: The phrase “rule of thumb” originated from an old law that allowed a husband to beat his wife with a stick no thicker than his thumb.
- True or False: Lemmings blindly follow each other and jump off the edge of cliffs to their death.
- True or False. The best way to secure your financial freedom is by maxing out your 401k or IRA each year to prepare for retirement by age 65. (Hint: this is the only important question.)
(Please pass your test sheet to someone else for grading—no cheating!)
- False. Thankfully, there is no evidence that any such law ever existed. (Maybe this was a joke all along to teach people not to blindly follow “rules of thumb.”)
- False. Lemmings don’t commit mass-suicide. There was a famous Disney documentary from the ’50s that perpetuated this rumor by showing a group of lemmings jumping off the edge of a cliff into the ocean where they supposedly drowned. But these poor lemmings were actually pushed off a hill into a river by the film crew. Sad story. (Even though this one isn’t true, you still shouldn’t blindly follow others—are you seeing the pattern here?)
- False. Saving a little bit of your income every year for retirement is certainly better than saving nothing at all, but it’s actually a sub-optimal way to build wealth.
Thanks for participating in this silly quiz! I hope it makes the point that sometimes we have to take a hard look at things that are generally accepted as being true. Since this is a financial blog, I want to take a look at the process of saving for retirement from question 3 (less exciting than the lemmings question, I know).
“Retirement” is basically another term for financial independence, but it usually takes people about 40+ years to save for retirement. If you’ve read some of my other posts, you’ll know I think that’s just too long. I want to see if there’s an easy way to speed up the process, without relying on unrealistic and risky investing strategies.
Your New Best Friend, Compound Interest
I’d like to introduce you to your financial independence BFF: Compound Interest. Some of you already know Compound Interest well, but in case you’re not so familiar, let’s learn why it’s so amazing by contrasting it with “regular” interest.
Say you earn regular interest of 10% per year for ten years on an investment of $10,000. Each year, you earn $1,000, so at the end of ten years, you would double your money and have $20,000 total (the $10,000 original investment plus ten $1,000 returns).
Compound interest is slightly (but importantly) different. The first year, you make the same 10% return of $1,000. But in the second year, you make a compounded return on both the original $10,000, and the reinvested $1,000 you made during year one. Thus the return from year two is $1,100 (10% of $11,000). During year three, you make a compounded return on the entire balance to-date, which is $12,100 ($10,000 initial investment, $1,000 reinvested from year one, and $1,100 reinvested from year two). Thus the return from year three is $1,210. After ten years of compounding your returns, you would have a total of $25,937—not really fabulous wealth yet, but an additional 60% over what regular interest would earn, which is nothing to sneeze at.
What’s The Big Deal?
The difference between regular and compound interest really becomes noticeable when you extend the time period of the investment. Over 30 years, regular interest would give you $40,000 total (the original $10,000 investment plus 30 $1,000 returns), while compound returns start to pull away, totaling $174,492. Over 100 years, simple interest would leave you with a total of $110,000, while compound returns put you safely in the “fabulously wealthy” category with more than $137 million.
Who doesn’t want $137 million?
But Who Has 100 Years?
That’s the problem… As much as medical technology has improved, I doubt I’ll be alive 100 years from now, and even if I am, I certainly won’t be getting much enjoyment from my $137 million. So as amazing as compound returns can be over long periods, we have to do something about that pesky time requirement.
The major variables in your journey to millions (or simply financial independence) are time and money, but these two variables do not interact in a linear fashion. For instance, using the same example of investing $10,000 for 100 years, after 80 years of compound interest, or 80% of the total time commitment, you’d have $20 million, or only about 15% of the $137 million total return over the full 100 years.
That means that the final 20% of time gives over 85% of the total returns. This phenomenon meshes well with our lack-of-time problem, because all we have to do is cut out some of those earlier years that aren’t doing much good. The only way to do that is to invest more money at the beginning of the investment period. For example, investing an extra $15,000 or so at the beginning (which is a minuscule fraction of the total end value) cuts off nearly 10 years from the goal of reaching $137 million.
How Does This All Relate To Retirement Savings?
I don’t think many people totally realize how time interacts with investment gains. Or if they do, they sure don’t act like it. Most people invest a tiny fraction of their income every year for their entire 40+ year career, and hope to end up with enough at retirement to live out their lives comfortably. But really what they’re doing is giving most of their money much less time on the market to grow and compound. On average, that person’s investment dollars will only have 20 years to grow, and assuming they receive pay raises throughout their career, most of their larger investments will be made later in life and have even less time to grow.
The solution is to simply invest more at the beginning of this whole process. That allows us to literally cut off decades from the time necessary to achieve our investment goals, and we won’t have to increase the total amount invested at all—just invest it sooner.
We need to give every single investment dollar the maximum possible amount of time on the market to grow.
This mindset is especially vital if you’re just starting out in your career. I unfortunately spent seven years in college and law school, which severely cut down the time my money could spend making returns on the market.
That schooling did increase my earning potential, but given how the market has performed over the past seven years, I probably would have a higher net worth right now if I had worked a lower-paying job and invested over those years—hindsight, huh?
Early Investments Can Take You From Retirement To Financial Independence.
Early investments have such a powerful effect on total returns that the entire paradigm of working for 40 years to be able to retire can be obliterated. By front-loading investments in the first few years, you can cut off decades from the amount of time you would normally have to wait around for your investments to reach any kind of meaningful dollar amount. That’s the whole premise of financial independence and early retirement.
Some of you may be nearing retirement, or may already be living on your hard-earned savings over a lifetime. You deserve congratulations for your consistent hard work! But these same principles can apply over a shorter time period as well, or at least hopefully demonstrate the huge benefit that could come from relatively small investment accounts started for your kids or grand kids.
What Are Reasonable FI Goals?
I have a nagging feeling that a lot of people are skeptical that they could ever save enough to retire early and still live comfortably. So let’s start with a goal that will be more than enough for most people—$2 million. Using the 4% rule, that $2 million will generate around $80,000 of income per year—forever, with little to no tax liability. People like Mr. Money Mustache live luxuriously on around $30,000 or less per year by eliminating useless expenses and focusing on efficiency, so I think my $80,000 yearly salary is pretty generous for most people—but feel free to adjust if you think you need more or less.
How Do We Get To $2 Million?
Let’s assume someone makes $100,000 per year, after taxes. I hesitate to use a fairly high salary in my example, but $2 million is also a pretty generous goal, so I think this example can be scaled pretty easily. Most people will save little to none of that $100,000 salary each year—spending it all on houses, cars, vacations, private schools for their kids, and Starbucks—and then try desperately to “make it up” in their ’50s and early ’60s. But we already learned that time is working really hard against them at that point, so let’s all agree that this is not the best route to take.
Assuming an annualized return of 10%, even if they put away $10,000 per year, or a mere 10% of their total salary, they’d end up with over $5 million by the time they retire after a fairly average 40-year work career—way more than we’re after in this example, but proof that anyone can retire a millionaire. They’d hit $2 million after only about 30 years, at which point they should probably move to the Bahamas! (Notice again that it takes 30 years to earn the first $2 million, but only 10 years to earn the remaining $3 million.)
Thirty years is still a pretty long time… What if we want to hit $2 million in 15 years or less? Since I’m changing the “time” variable now, we’ll need to change the amount invested as well. By moving up to investing $50,000 per year (50% of income), we could reach nearly $2 million in just 15 years.
If someone started working after college and did this, they’d be able to retire in their 30s. More likely, that person would just quit their day job, start doing something they really love since they’re no longer driven by financial concerns, and find out that they earn even more money pursuing their passions, making the whole experiment kind of useless to begin with. I wish most of us were brave enough to do this in the first place!
Obviously every situation is different, and there is no way to give a one-size-fits-all example. Some people might laugh at the idea that $2 million would be enough for them to retire, while for others, investing $50,000 per year sounds impossible (although I bet if some people just stopped buying liabilities, it would be pretty easy!).
But that wasn’t the point of this article. If you remember one thing—regardless of your income level, future spending needs, or time horizon—just remember how time affects the eventual value of your portfolio. If you really want to either maximize the size of your portfolio, or minimize the number of years that it takes to reach your financial goals (or both), you need to focus on giving every single investment dollar as much time as possible on the market to grow. There’s no way around this. An investment today is worth many multiples of that same investment made in the future.
I encourage you to front-load your investments to an extreme. Instead of feeling a little bit of financial hurt as you save 10% of your income for retirement over 30-40 years, make yourself really feel the pain over 10-15 years. My wife and I currently save and invest over 70% of our after-tax earnings, and I can tell you honestly that we buy anything we want, eat out whenever we want, and take all the vacations that we want. We just don’t live a consumption-oriented lifestyle. I have found that over-consumption adds nothing to my fulfillment and happiness. In fact, the knowledge that we will have more wealth (and time to enjoy that wealth) than we ever thought possible is more than enough to offset any pain in the present that comes from making smart spending decisions.
I encourage you to start making rational financial decisions, and that means making massive investments right now. Yesterday was a much better time to invest, but yesterday is already gone.
Make sure you don’t wait until tomorrow!