Achieving financial freedom is like climbing a mountain. As you take your first steps you know there is a huge challenge ahead. You also know you’ve only got limited time to reach your goal before the sun sets. But the view from the summit is spectacular and well worth the effort. It’s a challenging climb, but everyone can do it if they want to. Strap on your boots and take a deep breath…
Before we get into today’s topic, I just want to let you know that I’ve been working on a special report, “The best ways to invest in gold”. This covers why you should invest in gold, the best ways to do it, and also the products to avoid. You’ll also discover something else that’s been kept a secret up until now. Look out for the gold report in your inbox next week.
The article “How much do you need to retire?” looked at the ballpark figure for how much you’ll need to survive two decades or more of retirement. Short answer: when you stop working, for each $1 you expect to spend each year you’ll need around $20 of investment capital.
A little pain now will save you a lot later.
A key insight is that relatively small percentage reductions to current spending lead to huge increases in how much you’re saving. A little pain now will save you a lot later.
“Don’t rely on this for your financial future” looked at government retirement schemes, like social security and government pensions. These promises to pay are government debts which may not be honoured in full when the time comes, especially if you’re still a long way from retirement. You need a private back-up plan.
“The four steps to financial freedom” looked at what you need do to take control. It focused on the first three steps: how to understand your current financial position…how to potentially cut thousands of dollars of waste from your outgoings, without hardship…and why you have to make saving your top priority, ahead of spending.
Today we’ll take a closer look at step four: investing to build up your assets. Once you’ve committed to saving a substantial amount, you then need to work out what to do with the money. You need an investment strategy.
As far as that strategy goes – especially when it comes to successful stock investing by private investors like us – I recommend you take a look at the following past articles, especially if you haven’t seen them before:
- Five things every investor must do
- Learn to control your inner monkey
- Stock investing for supermodels
- Successful investors need these two things
- Make mine a double (the essential, but little understood, Power of Compounding explained in simple terms)
Beyond investment strategy, we’ll also take a look today at how much you’ll have to save and invest if you want enough funds in future, whether fully retired or not. The mountain’s peak may be well above sea level, but everyone can make the ascent if they set their mind to it.
Here’s the first thing to note. Over short periods of time it’s the amount saved in the first place that matters most. Over very long periods of time it’s the average return on the invested money that most influences the final result.
Here’s an example. Let’s say you save $10,000 this year, and increase that amount in line with annual inflation of 3% over time. So next year you’ll save $10,300, and keep increasing by 3% a year each year. And let’s say the money is invested and makes 5% a year on average, after taxes and fees.
(Note: in reality most people save less early in their working lives but should be able to increase it substantially as their earnings rise later on. But this is just an illustration.)
After 10 years you’ll have invested funds worth $142,489, of which $114,639 will be the total amount saved and $27,850 will be the total investment profit. In other words, just over 80% of the money will be the amount you saved and just under 20% will be the investment profit.
But this balance changes significantly the longer you keep at it. Under the same assumptions, after 20 years you’d have $423,593. Of this, $268,704 is the amount initially saved, or just over 63%. The investment profit would be $154,889, or just under 37% of the total. In other words, the longer period has shifted the balance from how much you saved initially to how much investment profit is generated.
Note how the saving period has doubled – from 10 to 20 years – but the total fund size is three times as big. The amount saved is up 2.3 times, but the investment profit is up 5.6 times.
This is the power of compounding in action, which comes from the profits you make on your previous profits. The longer the time scale the bigger the effect.
This is the power of compounding in action, which comes from the profits you make on your previous profits. The longer the time scale the bigger the effect. That’s why it’s so important to start saving and investing as early as possible in life.
Increase the time to 30 years and you’d have a fund of $947,340, of which half comes from initial saving and half from investment profit. Someone who did this for 40 years would have a little under $1.9 million at the end, of which 40% would be the initial savings and 60% the investment profit. Here’s a chart summarising the split in this example.
This shift effect is even greater if the investment return is higher, and vice versa. For example, at 7% net return and after 30 years the proportion from investment returns increases to 63%, from 50% at 5% a year. At 3% it’s just 33% investment profit over that time.
This highlights the importance of saving as much as you can, this year and every year. But it also highlights the importance of having an investment strategy that gives you a decent return. (OfWealth exists to help you with that.)
Say you did the same thing but left the money in low return bank deposits and bonds for 30 years, yielding 1% a year overall. That would leave you with 43% less money than a strategy that returned 5% a year, after taxes and fees. And you’d be 58% worse off than a 7% strategy.
The only realistic way to get average net returns over the long run in the 5-10% a year range, and possibly more, is to invest in stocks. Or at least you’ll need most of the money in stocks, most of the time (see the article links above for more on how and why).
Both saving and how you invest the savings are hugely important. The later you start the climb to financial freedom – and the peace of mind it brings – the more aggressively you will have to save.
But even if you’re, say, 60 years old the chances are you’ll be investing for 25 years or more. So whatever your age you need to have a good, long term investment strategy that will bring you decent profits and make your money last longer.
Now, let’s take another look at the size of those funds that you need. Remember, in my example – which started by saving $10,000 a year, increasing it with inflation, and investing at 5% net – after 30 years you’d have $947,340.
If we say that you can withdraw $1 in year one for every $20 of the fund – for it to last 20 years if invested at 5% – then that would give you an income of $47,367 a year. Sounds pretty good.
The trouble is that’s expressed in future money terms, with 30 years of accumulated inflation added on. Expressed in terms of its value today – which is known as “present value” – the fund would be $390,292. The income you could safely withdraw drops to $19,515 a year, in terms of current purchasing power. Certainly useful, but nowhere near so good.
To solve that you’d either need to save even more, or you’d need a higher average investment return over time. Here’s a summary of how the fund would look, expressed in today’s money (present value), depending on how long you were saving and investing for, and how much the net investment return works out to be.
(Note: the net return figures are “nominal”, meaning they include 3% annual inflation, not “real”, meaning inflation has been deducted. But the future fund balances are adjusted to show them in today’s money.)
Looking at these figures one thing is clear. Achieving your financial freedom means climbing a big mountain. No one said this stuff is easy. But it’s certainly worth giving it your best shot.
Anyone can do it with a combination of hard saving, a good investment strategy, and the application of time…and compounding. I recommend you strap on your boots, take a deep breath and get climbing…before dusk falls.
Stay tuned OfWealthers,