The Importance of the Time Value of Money for the Young Investor
“Don’t get old.” This is advice I often hear from my parents; but, whether we like it or not, the passage of time and the aging that comes along with it, is a force that cannot be controlled. As a recent college graduate with over a year in the workforce under my belt, optimizing each and every dollar is something I worry about often. Like most young professionals beginning their financial journey, dollars are few and goals are plenty. Typical priorities include saving up for a house, a new car, or a dream wedding, but what often gets lost in the shuffle is the formulation of an endgame, which is retirement. For many of us, retirement– something that is thirty to forty years in the future – is easy to put off or even forget altogether, so what I hope to illustrate today are the consequences of preparing early vs. starting late.
Let’s start with the “preparing early” scenario. Imagine that you are 25 years old with a goal to retire at age 65. That is equivalent to 40 years of work life, or accumulation period. From the beginning, you are conscientious about retirement and understand that it is important to save money for the future. Your plan is to take $100 of your paycheck each month after tax, starting at age 25, and put it into a Roth IRA. At the end of each year, it would equate to $1,200. Assuming you did this every year for 40 years and invested the proceeds into an investment portfolio and hypothetically earned a 7% annual rate of return (a conservative estimate for an 80% Stock/20% Bond Allocation), the ending value of your account would be $239,562.13. That doesn’t sound too bad, does it? The total amount invested would be $48,000 total ($1,200 x 40 years), with the result of those investments totaling to almost five times that amount.
Now, let’s explore the “starting late” scenario wherein you wait to start investing until you are 35 years of age instead of 25 years of age. In this case, you would still invest $100 monthly and earn a 7% annual rate of return, but the ending value of your account would be just $113,352.94. This is substantially less than the previous scenario of $100 invested monthly over a 40 year time period. By starting 10 years earlier, you only needed to invest $12,000 more; however, the ending value of your account increased by approximately $126,000.
What would happen if you waited until age 45 to start investing for retirement? In order to make up the difference for the late start, you decide to invest the current maximum contribution for a Roth IRA, $6,000 for those under age 50, until you retire. This is equivalent to investing a total of $120,000 (20 years x $6,000). At age 65, and assuming a 7% annual rate of return, your investment of $120,000 would be worth $245,972.95 (this is only $6,410.82 more than our original scenario, but to reach this point starting at age 45, you were required to invest two and a half times your original amount).
On the flipside, keep the $120,000 of principal invested, but spread it over 40 years instead of 20 years. In this case, the monthly investment would be $250, with the annual investment totaling $3,000. With a 7% rate of return over 40 years, the future value of the investment would be $598,905.34.
You get my point – we could run 1000 scenarios, each with different annual rates of return and amounts invested, but the most important message to take away is this: start investing early! Time is your greatest asset and it needs to be utilized to work for you. A good way to make sure you are taking advantage of the time you have is to set up automatic monthly contributions so that savings are pulled directly from your bank account. This will allow you to add money each month to your account without having to think twice about it. If you are someone who has waited a little bit longer to start investing for your retirement, do not feel defeated. It is better late than never, but address your retirement planning with some urgency. Your future self will appreciate your initiative.