The hot topic in the recent election debates seems to be around personal wealth and class warfare. That got me thinking about how do the rich really get richer. Are they really just that much smarter than the 99%? or perhaps luckier? Intelligence and luck are certainly factors to personal wealth, but there are two more factors that I think are truly the path to financial stability: Discipline and the power of compounding.
The 401k Savings Model
Recently, after taking a look at my 401k plan, it hit me that this is the account that I do not monitor, but yet, this is the majority of my personal savings. How does that make sense?
I started contributing to my 401k in my middle 20s when I began a stable career in finance. Each year I contribute roughly $16k (the maximum allowed annually by the government to the 401k plan), which is spread out over 24 pay periods. Essentially, I set aside $600 to 700 every two weeks to my 401k retirement account. And on top of that, I am putting the money to “work,” which means the money is invested in mutual funds and all the savings contributed each pay period is getting the benefit of compounding investment returns. Why is that important? Like Charlie Munger from Berkshire Hathaway once said, “the first $100,000 is a bitch,” but the power of compounding will begin to work for you in a significant way down the road.
The Road to $3.4M From $1,000
The 401k savings model is great, but it is just paper money until you hit retirement age. With that said, what we can do is take that savings model and create a plan that is more liquid and feel like “real” money.
What you will need:
1) a financially stable job with steady income
2) budget a predetermined disposable income amount that you can live without each month
3) sign up for an investment account
4) a whole lot of discipline
The whole idea is to stash money away in a liquid account, so you will be able to access any time if you need it, but ideally, you should only be checking the account maybe once a month or two to monitor the performance or to re-balance the portfolio.
Three Phases of Savings
If I could convince my-18-year-old-self to execute this savings plan, I would be at least a decade ahead of this timeline.
I will breakdown the plan in three basic phases: student phase, young professional phase, and retirement phase. At each step of the way, we will rely on savings and investment returns to grow the networth.
Savings is just what it is, ideally stash away a set amount each paycheck would work. As for investments, younger investors should be able to be more aggressive, therefore, should not hesitate to invest in 100% equities (as opposed to safer bonds). The logic is that, if you lose a significant amount of your savings in your early age, you will have time to make it back. You also want to be more aggressive in the early stage to attain that large bankroll you need get the ball rolling and let the savings “snowball.” As you get more experienced and settle in your career, you should begin to pick up some safer fixed income assets to keep the network you have built.
For this retirement calculator, we will assume a conservative 3% annual return for bonds, and 10% annual return for stocks. Some may argue that 10% is a bit optimistic, but historically, the S&P 500 index has returned on average right around 10% over the years, and if you have enough to invest with successful hedge funds, you may return well over that 10% benchmark.
The idea is to begin saving right around the time you start college, which is typically about 18 years old. The amount you start with at this early stage is not important, but lets just say you have $1,000 saved up from part time jobs and allowances, then you continue to contribute $150 every two weeks to the account for the next 12 years, this breaks down to about $10 a day, so it is conceivable even for a young college student. Every time you deposit into your investment account, you will continue to accrue the same mutual funds or ETFs that you have previously strategized for. By the time you reach 30 years old, combining all the deposits and compounding investment returns, you should be on track to have about $85k in savings (in form of liquid stocks, mutual funds or ETFs).
Young Professional Phase:
Of course staying discipline is not easy at an early age. Suppose your income in your college years is a bit light, or the market return is a bit lower than usual, you start your next phase with $50k. Now at around 30 years old, your career should begin to stabilize, which means a more steady income, stashing away $300 every two week can be done with a little bit of budgeting. By the time you are 40, your investment account should be right around $288k in a regular economy and market conditions.
From the time you hit your 40s, you should really began to plan on the future and save more aggressively for retirement. Luckily, through the discipline savings plan you executed brilliantly over the last 20 years, you have about a quarter of a million in liquid assets that you can grow into a significant amount. Again, assuming a regular economy and market conditions, in 30 years or so, that same $250,000 could conceivably turn into $3.4M through steady savings and compounding returns.
Key to Financial Freedom
As illustrated, I truly believe the best way to financial success is two fold, saving with discipline, and taking advantage the power of compounding. Let me leave you with this, if you started today with $1, and added $1 every 2 weeks, then compounded the growth via investments with 10% annual return, at the end of 30 years, you will have $4,538.65. Think about that, $1 today can balloon up to 4500 times its current worth 30 years down the road with a bit of discipline and investment savvy.
The plan described requires discipline and favorable market behavior, but it is a 40 to 50 year long term plan, and I have no doubt it that can be executed by most people. For more information on the retirement calculator used to forecast the savings plan, check out this Google doc retirement calculator I put together. The calculator should be mostly self explanatory. The orange cells are the inputs for your assumptions, and the cells in blue are the long term savings amount. It is a read-only spreadsheet, so in order to use this spreadsheet and enter your own assumptions, you must first save or download your own copy of this spreadsheet.