Three Money-Making Concepts

The stock market started out this year a lot of negative volatility and has many investors worried that the next ‘crash’ is just around the corner. First know that it’s impossible to predict what the stock market is going to do and when it’s going to do it. It’s also very instructive to remember that since the year 2000, as investors, we’ve lived through two of the three worst bear markets in the history of the stock market…and not only survived, thrived! Your best strategy, if you’re still working, is to have a systematic investment program that includes periodic rebalancing between your predetermined stock versus bond allocations. This reminds me of three important financial lessons for anyone searching for financial success.

Invest early (in life). When most people think about investing on a monthly basis, they tend to think of growth of their account in ‘linear’ terms. A linear progression is a straight but rising line. However, the effect of compounding creates geometric progression or a line that is rising but also ‘bending’ upwards. The importance of time in the equation of wealth accumulation cannot be underestimated. The compounding effect becomes more pronounced with the passage of time. A quick example will dramatize this point.

Investor #1 at age 19 invests $5,500 into an IRA account and continues to do so each year until age 28, thus having invested a total of $55,000.

Investor #2 waits until age 29 to begin his investment program and invests $5,500 per year in an IRA account until he is ready to retire at age 65, thus having invested $203,500.

Both men invest in the same index mutual fund, which earns an average of 8% annually. The results at age 65? Investor #1’s account is worth $1,484,000 while investor #2’s account is worth $1,200,000. The first investor paid a lot less money in yet has a significantly larger account. Parents, here’s a tip: If you have a child who is working, consider ‘matching’ their earnings up to $5,500 by investing in a Roth or traditional IRA for him or her.

Invest early (in the year). Many people will wait until about April 15 of this year to invest in their IRA for 2014. Instead of waiting until the last possible moment, there’s a big advantage for those who invest, instead, at the earliest possible moment. Let’s look at twin brothers, age twenty-five, who both are committed to invest $5,500 into their IRA each year with the goal of retiring at age 65. One invests in January of each year while the other waits until December 31st of each year. We’ll assume earnings of 8% annually. At age 65, the early investor’s account is $1,668,000 while his brother’s account is $1,544,000. The difference, $124,000, is a tidy little bonus for the early investor.

Prioritize investment contributions. Having worked with several hundred clients over the past 30 years, I’m still astounded that everyone doesn’t contribute to their employer’s 401(k) plan. In one case I was performing a client review and asked why he was not contributing to his employer’s 401k plan which the employer matched dollar for dollar up to six percent of salary? His response was that he ‘could not afford to’. I reviewed his expenses and found that he was ‘investing’ in a cash value life insurance policy and a mutual fund. It took him a few minutes to realize that his investment in his 401(k) plan ‘guaranteed’ an immediate return of 100%! No personal investment was going to produce that result. The chart below compares the difference between a thirty-year-old investing $10,000 per year into fully matched 401k plan versus taking the $10,000 as compensation, paying taxes (25% effective tax rate) and then investing personally. Eight-percent earnings are assumed with age 65 as the retirement date. At age 65, the smart investor has over $4,000,000 in his company plan while the ‘after-tax’ investor has $1,500,000. I should note that the four million in the 401k plan will face taxes as withdrawn but I also ignored potential taxes on annual earnings for the after tax plan.

One final note. All of the investors accumulated a lot of money which points out the importance of ‘just getting started’ with a systematic investment program!