The book The Millionaire Next Door revealed, for the first time, that there were strangers living among us. No, not zombies or even Tennessee fans, but rich people, only disguised as you and me. The authors assumed the rich in this country were those living in the most expensive neighborhoods and driving the fanciest cars but, after extensive interviews and research, they discovered many of those that had actually accumulated $1 Million or more in actual wealth – meaning savings – were leading more prudent lives. And, as a lesson for all of us, these regular, everyday millionaires had followed five key strategies to build that wealth.
My post titled, You Aren’t What You Drive covered the first key strategy of living beneath your means. My post titled, How Much Do You Really Need for Retirement emphasized the importance of having a financial plan to guide how much to save. Now, we discuss a third key called the magic of compound earnings, which could also be called, start saving and investing at an early age.
Albert Einstein supposedly said, “Compound interest is the eighth wonder of the world.” Simply put, compound interest or earnings means one earns not only a percentage on your original investment, but also earns on the earnings from last period too. Huh? If you invest $1000 and make 10% in a year you will then have $1100, an increase of $100. Now, if you also make 10% on your new total investment of $1100 the following year, you will then have $1210, an increase of $110. Cool, huh?
Why is this important? Because compounding really only achieves amazing results over time, so start early. Take two examples:
1. Phoebe is 35 years old and makes $50,000 per year. She decides she will contribute 15%, or $7,500 per year, into her retirement account until she retires at age 65. During that time, she will earn raises of 2% each year while continuing to contribute 15% of her salary. Assuming an average rate of return on her investments of 7%, when Phoebe turns 65 she will have accumulated wealth of $1,022,306.
2. Joey is 55 years old and makes $80,000 per year. Joey spends almost all his money on clothes and sandwiches but decides he should probably get ready for retirement in 10 years. He, too, decides to save 15% of his salary, $12,000, over the next ten years and also receives raises of 2% each year. When Joey turns 65 he will have accumulated wealth of $182,315. Uh oh. So, Joey decides to save extremely aggressively and puts back 30% of his salary, $24,000, over the next ten years. Now, when Joey turns 65 he will have accumulated wealth of $364,630. Better, but not enough to live on for another 20 years.
The lesson learned here is, don’t be Joey, be Phoebe and start saving and investing early. You don’t have to save as much out of your paycheck each month if you have time on your side. If you’re closer to retirement and don’t have enough saved, you’ll have some tougher choices to make such as working longer than you wanted and/or cutting expenses dramatically in retirement.