I promised this blog wouldn’t be full of a bunch of advice as there are multiple ways to skin the wealth-building cat. However, it seems any PF blogger worth their financial salt has their go-to wealth-building tip that they feel most helped them get to where they are.
For some, it is to never own a car and live in an area where you can bike to work. For others, it may be that dividend, index fund, or peer-to-peer investing trumps all else. Further yet, buying rentals and becoming a landlord is another silver bullet that some may preach.
All of these are doable and great options. However, the only way to get to a point where you can do these things is to have the money to do so first.
So here it is, Buck’s first and foremost wealth-building tip (drum-roll please)…
INVEST YOUR SAVINGS EARLY! (like right now)
Did you just feel the ground tremble beneath your feet? Yeah, me neither. If you are a wise buck, you understand the power of this statement. But this post is directed at you young bucks new to the scene.
If you are just starting your journey to building wealth and you are of the inquisitive type, search out everyone you know who has their fiscal wits about them and ask if they could go back in time, what one thing would they do differently with regard to their money. I suspect their response will be able to be boiled down to one of the following:
1) I wish I had started saving earlier
2) I wish I knew then what I know now
What I guarantee you won’t hear them say is “Geez, I wish I hadn’t saved so much when I was younger and should have spent all of my money on fast cars and faster women.”
This is because the element of time is such a big part of the equation to building wealth. Let’s face it, for most of us this won’t happen overnight or even over several years for that matter. It happens over decades. Time is the constant, unwavering march of existence that can be used to our advantage.
Let’s unpack this a bit more to make sure we understand the three (3) levers you have when it comes to building up your stash. Below is the mathematical formula for compound interest and includes those levers – all on the right-hand side of the equation.
Hold on! I can see your eyes glazing over from here. But please, bear with me for one minute. Albert Einstein once referred to it as mankind’s greatest discovery and later called it the Eighth Wonder of the World. With that kind of endorsement, how could you not continue reading? Some quick definitions:
FV = Future Value of your stash (how much your money will be worth at some point in the future)
PV = Present Value of your stash (how much you have saved right now)
i = Interest (or return) rate for a year
n = Number of years invested
Fun with Abbreviations
FV should be your goal. You want to be a millionaire? billionaire? Great, put that on the left side of the equation and the levers (variables) on the other side will help you get there. PV is the current size of your invest-able stash and it doesn’t matter if it is in Dollars, Euros, or Gold-Galleons. The element of time is represented by n and for this illustration should be in years.
For young bucks, you should first focus on the PV and n portion of the equation. Once you have some PV and n on your side, that is when you should start maximizing your i (rate of return). It makes no sense to focus on i without PV.
What’s that you say? You don’t know your PV (roughly equal to Net Worth)!?
Pop Quiz Time!
Q1: What happens if your PV is negative or close to zero?
Q2: Let’s say a magic genie could grant you one wish. And your one wish was limited to doubling the value of just one of your three (3) levers to building wealth. Which would you choose to maximize the future value of your stash (FV)?
As a quick review, the three (3) levers at our disposal are how much money you have saved (PV), the time (n) and interest rate (i) at which the money is invested.
A2: This is a bit of a trick question. To answer properly, let’s walk through two examples.
Example 1: Let’s assume we have $10,000 invested at 7% for 5 years (PV = 10,000, i = 7%, and n = 5). This results in a future value (FV) equal to $14,025. **
Double i to 14%? This results in a FV = $19,254.
Double n to 10 years? This results in a FV = $19,671.
Double PV to $20,000? This results in a FV = $28,051.
Example 1 shows that if our genie doubled our stash (PV) that we would end up with the most money after the short 5 years.
Example 2: What happens if everything in the scenario stays the same (PV = $10,000, i = 7%) except instead we’re talking about decades (n = 20 years)? Future Value (FV) in this case is $38,696.
Double PV to $20,000? This results in a FV = $77,393
Double i to 14%? This results in a FV = $137,434.
Double n to 40 years? This results in a FV = $149,744.
Example 2 shows that when we’re talking about decades of time, doubling our money (PV) is actually the least impactful thing we could do. This means, for most folks earning their first significant money in their 20’s and needing to use it in their 60’s and beyond, there is no greater thing you can do than start saving (and investing) early by maximizing n (time).
Our household didn’t amass the nest egg we did because we’re brilliant investors or business whiz-kids…we were able to do this in spite of our mistakes. The greatest single action both Mrs. Buck and I took 15 years ago when we first started working full-time was to immediately start saving for retirement. Since we are in the U.S., this meant maxing out our retirement contributions to the legal limit.
In 1998, the 401K retirement contribution limit was $10,000 per person per year. A quick calculation with some simple assumptions shows that first year of contributions ($20,000 total) now probably makes up about 8.5% of our retirement stash and is valued around $55,000.
And because that money is in tax-deferred retirement accounts that we won’t tap until age 60 or later, those contributions will continue growing exponentially because our n (time) will march on. Because we invested early, the value of those dollars now have rocket-boosters strapped to them and will translate into over two more decades to compound and reproduce. By the time we’re age 60, that single, initial $20,000 investment will be worth around $230,000.
The magic of compounding is an exponential proposition and there are a bunch of additional illustrations out there to demonstrate this. The beauty of saving and investing with decades of time on your side is that you don’t need to take on outlandish risks investing your money to have it grow to outlandish levels.
** Math challenged? There is a great Compound Interest calculator (among a bunch of others) over at FinancialMentor.com that I use on a frequent basis.