People entering the workforce face a mountain of new financial scenarios, and face them in rapid succession. While they might choose to repay loans or buy cool gadgets, they also should consider that their younger years are simply the best time to invest.
A Real Paycheck
I still remember the realization that “real” money would now be filling up my savings account on a biweekly basis. I had the extra cash to buy all those things I’d always wanted—sweet!
But simultaneously, real bills started showing up. Lame! Student loans, cars payments, and monthly rent. And then there were the weekly groceries, my gym membership, gas and utilities.
I had no shortage of options (and requirements) to spend this new money. You are (or were) in a similar boat, I bet. A young person’s personal finances are stretched thin. And did I mention an emergency fund?
Despite all of these expenses, it turns out that your younger years are also the the best time to invest in your retirement.
I know it’s lame. What 22-year old wants to plan for being 60? But I hope that the following math (did this article just get more lame?) will convince you.
First, we have to think about how long a typical career might be. I’m going to assume that our average worker, Wallace, enters the workforce at 22 and retires at 62. That’s 40 years of solid work.
Next, we have to think about Wallace’s retirement account and how it grows. Wallace is a simple man. He uses dollar-cost averaging to buy S&P 500 index funds. He doesn’t need an investment advisor to navigate the market conditions for him, and he doesn’t try to time the market. Wallace has a long-term time frame.
Some years will be great for Wallace—the stock market will boom in a bull market and Wallace’s investments will bloom. Other years will be bad—a bear market means sad Wallace. But these short term rises and falls won’t affect Wallace too much.
Over time, historical data tells us that the market averages out in a positive way—the boom and bust volatility averages to a rate of return of 9% per year for Wallace’s investment portfolio.
The money Wallace invests on Day 1 will have 40 years to grow at 9% per year. Year 20 money will have 20 years of growth, and so on.
Well, how much more does the Year 1 money grow than the Year 2 money? …than the Year 5 money? …than the Year 20 money? Let’s phrase these questions a different way: if Wallace doesn’t invest in his 20s—Years 1 through 8—how much growth did he lose?
The answer to these questions involves compound interest. It’s the idea that your money grows, and then the new growth grows, and then the growth’s growth grows. Compound interest acts like a tree; every new branch (growth) sprouts off its own new branches.
See Wallace’s money grow
Wallace’s Year 0 money grows for 40 years at 9% each year. You might be tempted to think: 40 * 9% = 360% increase. But that’s not quite right. That’s “simple interest.”
Instead, you should take 9% growth (or 1.09) and raise it to the power of 40, or 1.0940 = 31.41 = 3141% increase. Whoa! Each $1 that Wallace contributes at age 22 will grow to $31 by the time he retires.
Let’s do the same thing for Years 10, 20, 30
|Wallace’s Age||Years until retirement||Math||Growth Factor|
The money Wallace invests at age 22 will grow more than twice as much as the money he invests at 32, and more than 10 times as much as the money he invests at 52. Crazy.
Note: this math does not take inflation into account! To look at some similar analysis that includes inflation, I recommend reading the end of this article.
Why Wallace’s 20s are so important
Here’s another way to approach this question. If we add up the growth factors for age 22, 23, 24 etc., and then do the same counting down from 62, 61, 60 etc., we should find a point where we can say, “The first X years of Wallace’s investment life are equally important as the final Y years.”
This happens for Wallace at age 29, after seven years of investing.
Wallace’s first seven years of investing contribute half of his final account balance. His final 33 years of investing contribute the other half. That’s how significant the growth of his early years are. That’s why your younger years are such a vital investment period.
Another quick data point. Wallace’s first year (which grows by a factor of 31.4) contributes an equivalent amount as his final 15 years (which only grow by factors of 1-3ish).
Before you cry foul, let’s think about inflation quickly. If we assume a 3% inflation rate, then Wallace’s “real growth” is only ~6% per year. In that scenario, Wallace’s first 10 years have the same growth potential as the final 30 years. It’s not as stunning as 7 vs. 33, but it’s still wild.
Wallace could invest $10K a year from age 22 to age 29 and never invest again, and he’d end up with the same amount of money as another person who invests $10K a year from age 29 to age 62. Wallace invests $70K over 7 years, the other person invest $330K over 33 years, but they reach age 62 with about $1.9 million.
That’s my point here. Your youth isn’t just a good time to invest. It’s the best time to invest. And a comparison of historical market conditions backs me up on that claim.
“I missed out on the best time to invest!”
I know it’s hard to invest early in life. All we want to do in pay off some debt, drive a decent car, have a roof over our head, and what the heck is wrong with having a little fun?! We finally have the spending power we wished we had as kids. But keep in mind how valuable the early years can be to your retirement.
“I’m 40 and this post has me depressed. I missed out on investing in my 20s and 30s, and now I’m filled with regret.”
Stop! Don’t worry about it. The past is immutable, and there is no time like the present.
So you’re 40 and have never invested a dime. That’s ok. Your next six years—age 40 to 46—have the same importance as the 16 years after that–from 46 to 62. The same idea from before applies here. The best time to invest was twenty years ago, but the next best time to invest is now.
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Thanks for reading the Best Interest.