Saturday, March 23, 2013

The Key to Successful Long Term Investing ... Start Early

Far too many of us choose to enjoy today to the fullest to the extent that we forget all about how we're going to feel about things tomorrow. Economists refer to that "todayism" preference as time inconsistency.

Time inconsistency simply means that we don't pay sufficient attention to our future needs when making choices about what we do now versus the subsequent effects of those decisions. The 'wants' of our present self are prioritized at a higher level than the 'needs' of our future self.

And that not fully considered choice of satisfying our present wants versus making provisions for our future needs generally works to our detriment over time.

As examples of time inconsistency in relation to our personal financial well being, borrowing too much on credit in order to buy such things as new cars, new houses, and even attend an expensive college as far away from home as possible are all part of the mix.

Time lost is gone forever, and tomorrow is never just twenty four hours later.

What we do NOW matter greatly to what we're able to enjoy TOMORROW. It's that simple.

Compound interest: You're doing it wrong has the sobering but all too true consequences of the "buy now, pay later" way of life:

"The latest data on our retirement readiness is out and it is, of course, very gloomy.

I won't drag you through the entire report from the Employee Benefit Research Institute (EBRI), since you likely know the bottom line: 57% of working Americans have less than $25,000 in non-pension, non-real estate savings and a shocking 28% have less than $1,000.

Nevertheless, 40% of us believe that we will need $500,000 saved up to retire well. The remainder picked lower numbers.

The figures suggest that the baby boomers are in for a seriously problematic retirement. They'll be more dependent on their adult children, on government programs and continued employment in their old age to get by. This we know.

The really troublesome part of the survey, however, is that younger people aren't saving enough, either, at an age when saving is most effective.

The EBRI study found that for workers ages 25 to 34 just 56% said they had saved money for retirement. Ten years ago, the number was a bit better; 65% of young workers were saving then.

It's after age 35 that most workers begin to take retirement seriously. The numbers reporting that they save money shoots up to 77% and remains high until the mid-50s.

That's getting it exactly backwards.

Yes, it's hard to save money when you're young and struggling. Jobs don't pay enough, students often carry college debt and the cost of living in places that generate jobs, our larger cities, can be high.

Nevertheless, it's during those five to 10 years right after school that people should hit their savings strategy head-on. The reason is compounding.

Let's assume a 25-year-old gets an entry-level job in a mid-sized bank as an accountant, making the average national salary for beginning accountants of $44,965.

There are a bunch of tax withholding assumptions here, but for simplicity's sake let's say our young saver puts aside $5,000 a year for 20 years — then stops saving completely.

At a market return of 7%, you can expect the roughly $100,000 set aside from her paycheck to more than double, reaching $218,500 by the time she reaches 45.

From ages 45 to 65, our accountant's retirement target, that money will compound twice more, that is, it will double and double again, ending up at $875,396.

Remember, she stops saving completely at age 45. The money grows on its own over the second, 20-year period.

Compare that outcome to the more likely scenario: Same accountant, same salary, but no savings at all until age 45.

How much must the second accountant save annually to get the same outcome? Double, maybe?

No, the second accountant must save four times as much money to hit the target by 65. She must scrimp and put away $20,000 a year to come up to $874,000 at retirement.

Here's the rub: Those 45-year-olds, increasingly, have to foot the bills that come with caring for aging parents with little or no savings and, somehow, also finance their own kids' lives and educations, on top of their own needs.

If you are under 30 and reading this now, you know your mission: Save more, pronto. If you're over 45 and find yourself staring at an empty bank account, that mission is not doubly urgent, but quadruply so.

And if you haven't sat down and made a serious plan — and EBRI reports that 46% of workers have at least attempted to do so — now is the time."

Summing Up

The sooner we understand and internalize the compounding effects of the rule of 72, the better our future financial lives will be. It's that simple.

But the evidence is overwhelming that the basics of compounding are not well understood and  that poor choices to live in the now versus preparing properly for later (aka time inconsistency) combine to work to the detriment of younger individuals as they enter and experience adulthood.

In fact, some over 45 year olds decide that it's too late to provide properly for themselves, so they essentially do nothing to prepare financially for their years as an oldster.

On the one hand, these very same individuals complain loudly about the evils of government spending, while at the same time they're complaining that their Social Security benefits should be higher. Go figure.

The bottom line is that financial literacy at a young age is absolutely essential for the future well being and prosperity of all Americans.

The baby boom demographics are real, and the financial problems affecting older Americans and the rest of society are going to be immense if we don't get a grip on all this, and soon.

At least that's my take. And if you agree, spread the word. It's up to us to do the right thing -- NOW.

Thanks. Bob.

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