We Need to Get Back to the Basics

I find myself saying this a lot more lately with everything in life. However, for this article I’ll focus on getting back to the basics with regards to investing. When starting an investment program, once you have set your goals, you need to determine your time horizon for savings. If you determine, you have a long-term time horizon (at least 5 years or more), stocks may have a purpose in your portfolio. However, in any given downturn for stocks, investors often begin questioning their long-term strategy. First let me put one thing in perspective. Many people think of their retirement date as defining their time horizon. Unless you are going to spend every dollar of savings on your retirement date, then your time horizon should be matched closer to your life expectancy. And even that’s only if you plan on spending your last dollar on your last day – which is not always a bad idea. If you plan on leaving an inheritance, then your investment time horizon is likely much longer than even your life expectancy.

Now that you decided you can truly focus on the long-term, let’s review the simplest basics of the stock market. It’s actually not as complicated as you might think. First, stocks have inherent risk – their value goes up and it goes down. Over time, they go up more than they go down thereby rewarding investors that take the risk. Assuming you have the tolerance for the ups and downs of the markets and we’ve already determined you have the time horizon to ride out those fluctuations – we’ll review the most important basic factor that determines return – compounding.

One of my favorite charts that I have used for many years reflects the effects of compounding. Although charts can give you an excellent visual picture, due to lack of space, I’m going to share the summary with you. We compare two investors which we’ll call Fred and Wilma. Wilma starts working at a paying job right out of high school. Being the more financially savvy of the two she starts investing $2,000 per year into her IRA at age 19. At age 26 she retires from the workplace to begin raising her family and as a result never adds another penny to her IRA. On the flip side, Fred, the same age as Wilma, liked to spend and didn’t contribute anything to his IRA until he turned age 27. Because Fred never left the workforce, he continued to add $2,000/year to his IRA until retirement at age 65 (nearly 40 years later). So, if Wilma contributed a total of $16,000 and Fred invested a total of $78,000 – who do you think had the most dollars in their account at retirement? Wilma! In fact, assuming each of their IRAs earned 10% per year every year, Wilma’s account would grow to a whopping $1,019,160. Even though he invested nearly 5 times the amount that Wilma invested, Fred’s IRA grew to only $805,185. In other words, Wilma’s contributions grew 64-fold while Fred’s grew 11-fold. That’s the benefit of compounding. While it’s never too late to start investing – remember Fred’s $78,000 still grew to over $800,000 – the earlier you start the better.

So in summary, you can get caught up and bogged down with all the financial news and data out there, or you can just choose to get back to the basics and: 1) start a savings plan at any time 2) focus on the long-term and 3) enjoy the benefits of compounding!