Thinking about saving money for the future can bring on a lot of stress for a few different reasons. You could be at a point in your life where you feel that you should have more saved for retirement. Or, you may think that saving is something that you’re still young enough not to worry about.
In any case, reducing debt and increasing assets is something everyone should be thinking about to some degree, and it doesn’t have to be seen as a chore. Here, we’ll break down the importance of starting a savings plan NOW, and the easy things you can do to reduce the stress of preparing for the future, both in the short- and long-term.
More than Retirement
In many cases, people underestimate the amount of money they need to save in order to maintain or improve their lifestyle in retirement. In these cases, an aggressive savings plan is required. On the other hand, many Millennials do not see the importance of saving money in our “tap-the-visa” society. Some may believe saving for the future only applies to those who are nearing retirement. Although retirement planning does apply to each and every one of us, there are many other reasons for Millennials to start saving. Here are a few in no particular order:
- Reducing student debt
- Purchasing first home/paying-off mortgage
- Purchasing income properties
- Rainy day fund in case of family emergency
- Growing investment portfolio
- Starting a business/non-profit organization
- Investing in a private business
- Children’s tuition
- Travel and other memorable experiences
Now that we’ve established that there are many reasons to save beyond retirement planning, we will now discuss why it is crucial to start saving now!
The Beauty of Compounding
“Compound interest is the eighth wonder of the world. He who understands it, earns it, he who doesn’t pays it” – Albert Einstein
The idea of compounding returns is that when you invest your money (or principal) you may earn a percentage return on your principal. If you then keep your principal amount and year one returns invested then your year 2 returns will be a percentage gain on your principal amount plus your year 1 returns. At first glance, it may seem complicated, but it is the simple concept of continuously reinvesting your returns so that subsequent returns will apply to a larger investment. It may not seem like such a magical concept, but it is at the heart of every great investment strategy and is understood by the world’s greatest investors.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest” – Warren Buffett
However, not all forms of compounding are made equal. Below we have two theoretical examples where people were able to compound at various rates over time. The first person (Person A) invests $2,000 per year for the next ten years and continuously compounded returns for 40 years. Meanwhile, the second person (Person B) didn’t invest right away, rather, they just invested $20,000 ten years from now, and compounded returns during the same time period (the next 30 years). The table below displays the amount each person would have after the 40 year period due to annually compounded returns.
|Person A||$ 80,996.40||$ 225,073.06||$ 611,816.77||$ 1,177,699.57|
|Person B||$ 67,462.67||$ 162,902.26||$ 383,886.85||$ 671,102.26|
This table highlights two factors of compounding that are crucially important. The first being that the rate of return compounded over time makes a huge difference. Thus, if you are losing 2% per year due to fees and commission on your investments it may not seem like much, but it’s worth a significant amount when you consider the compounding value of those fees over a lifetime. Second, Person A who saved and invested $2,000 per year during the first ten years had drastically better performance in the long-run. It is important to start developing a habit of saving money now because even small amounts compounded over time will produce substantial gains.
Jeremy C Miller, author of Warren Buffett’s Ground Rules noted some helpful advice about compounding:
“If you can manage to underspend your income while achieving even a modestly better than average return, you are likely to be just fine financially”
The moral of the story is the sooner you start saving and appropriately invest those savings, the longer your returns will compound. Beginning to save now will allow you to maximize the effect of compounding.
Developing a money-saving plan isn’t always an easy task. Tight times and life’s curveballs constantly demand our monetary attention. Fortunately, there a few things we can do that will help make saving a long-term habit.
Step-one to growing your savings is to first be aware of your spending habits. It’s no secret that in order to save money you must earn more than you spend. Despite the simplistic nature of this statement, it is where many of us falter.
Many technical advances have dissociated us with the act of spending money. Credit cards allow us to postpone payment while also taking away the actual act of handing over cash. It is easier than ever for us to lose track of our spending habits.
Luckily, technology can also help us get our spending under control. Apps such as Mint track your spending and even provide a breakdown of what you’re spending your hard-earned money on. It may be surprising to some to see where the majority of their money goes. Once we are consistently earning more than we spend we can start putting money away.
Reducing Debt and the “Deal-with-it-later Card”
Reducing your debt should be one of the first priorities of any savings plan. As you reduce your debt you are instantly saving the value of future interest charges. Simply compounding these amounts over time will build a solid foundation for your long-term saving and investing plan.
One of the best things you can do financially is paying down your credit card on a monthly basis. The annual interest charges of 18% and up on credit cards these days is just sickening. There is no reward points system that justifies that expense. Getting in the habit of paying down your credit card every month will make a profound impact on your long-term savings plan.
Pay Yourself First
This is an easy habit that we can all do. Start by taking 10% of every pay and putting it in your savings account. You can use these funds to pay down debt or as part of your investment strategy. 10% doesn’t seem like much but it will add up. Remember, even compounding small sums of money makes a substantial difference over time.
The key is consistency. Consistently saving 10% of each pay for years is better than saving 50% of your pay once. We’re trying to develop a habit of saving here. Once you feel that you can comfortably save more go ahead and increase that percentage. Sticking with the pay-yourself-first strategy will ensure you are always saving a portion of your income.
. . .
There’s no time like the present when it comes to saving. Whether your financial goals are long-term in nature, such as retirement, or short-term, such as saving for a down-payment on a home, developing a habit of consistent saving is key. Even if you have short-term saving goals, if you can allocate even a small portion of your savings to appropriately invest for the long-run, you will maximize the effect of compounding and be well on your way to financial freedom.
Breaking the Trend
- Warren Buffett’s Ground Rules – Jeremy C. Miller: Highly recommend this book to anyone looking to learn more about value investing, especially with regard to investing modest sums of money. Jeremy C. Miller also includes a great chapter on the importance of compounding in this book
- The Wealthy Barber Returns – David Chilton: A great well-rounded, easy-reading personal finance book that will help anyone think through financial problems and decisions
- Mint – Personal finance app to help you keep track of your spending, build a budget, pay bills, and check your credit score