Anyone who saves, invests, or speculates is stating an opinion on investing and has a future goal in mind. The road from an opinion to setting a goal requires a prediction and a choice.
Someone who decides to save $833 per month ($10,000 per year) in a savings account at 3.5% per year and never withdraws a penny may not know that he or she will have $870,208 in the bank at age 65. But the prediction was that the money put in would be safe from loss of the capital and make a decent earning. At that 40 year retirement point in the future the 3.5% saver could earn $30,457 per year in interest at the same rate.
The saver also doesn't yet know that at that point 40 years ahead he or she could annuitize the $870,208 by buying a Vanguard AIG immediate annuity (or from otherr companies at at today's rates) and receive monthly payments for the rest of his or her life totalling $74,148 per year. And only 40% of the payout would be taxable since this saver had paid taxes on the interest during 40 years of savings. Also the saver would have perhaps $24,000 per year in Social Security payments at or about age 65-68. So for a simple and safe savings program with a very modest return, the saver could end up with $100,000 in annual retirement income even if he or she did nothing else but save $833 per month and pay Social Security taxes through a job for at least ten years!
Granted that 3.5% per year isn't very much, but in the US the consumer price index has increased at about that same rate on average over the past 40 years. The key issues are that the saver started while young, consistently saved the same amount every month, paid tax on the interest income, and never touched a penny of the savings or interest. Each one of those four conditions is necessary to make maximum returns for retirement.
Also a prediction or the acceptance of a return of only 3.5% per year is very likely to be correct. The risk of not achieving the goal implied by the 3.5% rate is very, very low. The same program of saving $833 per month (equals $10,000 per year) with an average return of 7%, or double the bank savings rate, would give you a total of $2,186,470 in 40 years. Doubling the interest rate gives you 2 1/2 times the total return due to compounding. However, you are not going to make 7% compounded for 40 years in a bank savings account. To make 7% you would have to venture away from a situation where you cannot lose any of your capital into a situation where your capital and rate of return can vary widely.
Forty years ago on June 1, 1967 the Dow 30 Index was at 855. So at the current price on May 18, 2007 of 13,556 the Dow returned 7.15% compounded annually on price. And you could add on an average of 2.5% in dividends per year which could also have compounded. But bear in mind that the Dow was only at about 825 on June 1, 1982, 15 years after 1967 when it was 855! You would have had dividends for 15 years of course, and you would have had more shares of the Dow by reinvesting the dividends, but there would have been nothing added from capital appreciation.
All of a sudden the 3.5% saver doesn't look so dumb in 1982. Venturing into stocks is therefore not guaranteed to give you 7% in your own 40 year savings life or in 20 years of retirement. Also in 1967 you couldn't have put $833 per month into the Dow as there were no indexes you could have invested in as there are now. So we see that the systematic saver at a low return (3.5%) does pretty well, and we see that stocks can have long periods of low returns. And we also saw, or heard, that stocks can go down dramatically as they did from 2000 to 2002. But over very long periods of time stocks will do better than savings alone. What do we do?
Anyone in his or her twenties now has tremendous advantages for personal savings and investment compared to 40 years ago. With no more action or thought than putting $833 per month into a savings account, you can now invest that same $833 in already set up combinations of stocks and interest rate funds. If you have an employer who offers 401K plans, you will automatically be enrolled in a 401K plan which will let you put in $833 (or whatever you want, up to certain limits). 401K plans will offer a no-brainer option of putting your money into an an age-related fund with some money going to a stock index and some to an interest rate index. As your age increases, your interest rate part of the fund increases to reduce your risk of loss.
This gives you a better long term rate of return than the bank, but it also has an interest rate component which doesn't leave you totally at the risk of no stock gains for 15 years as happened from 1967 to 1982. When you are in your 20's you can take more risk of having a 1967-1982 period happen to you. But gradually as you get older you will not want as much risk and you will want more of the relative certainty of interest rate income.
The new 401K plans can now automatically increase your interest rate investment and reduce your stock exposure as you get older. All you have to do is authorize withholding the $833 per month (or whatever amount you adopt) and the plan does the rest with no planning or worrying by you. None of the returns are guaranteed, of course, but truthfully neither was the 3.5% for savings. Banks savings account rates can vary as well. But just as 3.5% is a reasonable prediction for a cash savings plan, so is 7% a reasonable prediction for a stock plus interest rate plan over a 40 year investment period.
For long term investment the best asset you have is to be young! Someone who starts saving or investing at age 50 isn't going to get rich and retire well. If you start at age 25 retiring reasonably rich is a slam dunk as long as you 1. pick a good monthly savings/investment amount from the start 2. set it up to happen every month and never miss a month 3. and never touch the savings or the earnings. You don't have to be a genius except once with this approach: and that is when you set up your plan and just do it.
If you are self-employed, or can't put as much as $833 into your 401K, you can do the same thing as with an employer 401K through an IRA, SEP-IRA, Roth IRA, or just with your own private mutual fund account. Many of the best mutual fund companies like Fidelity, T R Price, Vanguard and others offer very low cost stock and interest rate funds which change with your age.
Do it while you have the most valuable asset of youth to work for you for 40 years!
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