To Get Rich Investing, the Power of Time Beats a Lucky Stock Pick

Each of these three investment moves has an amazing lifetime payoff, especially if you (or someone you know) can start in their 20s. Do them all, and you could be set for a very comfortable retirement.

1. Start early

You can turn yourself into a multi-millionaire by saving for retirement for just five years. Start at 25, and you will be giving yourself the greatest gift an investor can have: time.

Sure, luck is important. But time is more important.

To see why, let’s assume that you’re 25 years old and you’ve decided that when you’re 30, you will start a long-term savings plan for your retirement. Further, we’ll assume that you will retire at age 70 (which in the year 2061 may be the norm.) That’s not a bad plan. But it could be better.

If you start now, at 25, five years of modest investments can leave you with millions when it’s time to retire, no matter what you do after you’re 30.

Here’s the setup: You’re 25 and you have a decent job. You don’t have tons of money to spare, but you figure out how to save $500 a month for your long-term future. That adds up to $6,000 a year, which you can put into an IRA, either a Roth (in which you’ll pay taxes on the $6,000 just as if you’ve spent it but get a huge tax break later) or a traditional one (in which you can defer taxes on the $6,000, making it less expensive at the moment).

Do that for five years and you’ll have invested $30,000.

During this five years, your investments are earning a return, though it’s impossible to know how much.

If we assume you receive the very-long-term compound annual growth rate of the S&P 500 index — 10.7% — your $30,000 would grow to $37,144 when you’re 30.

Good luck, bad luck

I mentioned luck, and it certainly applies here.

  • If you are unlucky enough to be 25 at the start of a string of years like 1970 through 1974 (with annual S&P 500 returns of 4%, 14.3%, 18.3%, -14.7% and -26.5%) your $30,00 would be worth only $22,998.
  • On the other hand, if you are lucky enough to be 25 at the start of a string of years like 1995 through 1999 (with returns of 37.5%, 22.9%, 33.3%, 28.5% and 21%) you’d have $65,323.

In any of these three cases, your $22,998 or $37,144 or $65,323 seems like only a tiny start toward $4 million. But every penny of it is money you won’t have if you wait until you’re 30.

Now assume you invest that money (and only that money) for the next 40 years in the S&P 500. Since 1928, the average 40-year compound annual growth rate of the index has been 11%. So let’s assume you achieved that from age 30 to 70.

Remember that this won’t be a straight line of 11% returns. There will be great years for the stock market, and there will be years where the market goes down and your portfolio shrinks. But we can’t see into the future, so history is the best guide we have.

Given these caveats and depending on whether you start (at age 30) with $22,998, $37,144 or $65,323, at age 70 you would have $1.49 million or $2.41 million or $4.25 million.

Those numbers came from only $30,000 of your own money – without assuming you invested anything after your 30th birthday. That’s why a long time horizon is so powerful in investing.

This plan lets the ups and downs of life get in the way after age 30. But I’m presuming that after five years of savings, you’ll have good habits and will continue contributing to your IRA, leaving you with more money (probably MUCH more) at age 70.

In the interest of balancing risks, that future money won’t be all in stocks, meaning not only will you have less time to invest but also will likely have lower returns. So consider this 100% equities investment that you made over just five years the jewel of your retirement portfolio.

2. Work for a generous employer

You’ll improve your results a great deal if instead of putting your money into an IRA, you participate in a 401(k) or similar retirement plan in which your employer offers a 25% match. That will add $1,500 a year to your own savings. (And in a way it’s like free money to you.)

Again using the three rates of return we assumed above (unlucky, average, very lucky), this employer match will leave you with an additional $5,750, $9,286, or $16,331 at age 30.

Those extra amounts, invested for the next 40 years at 11%, would add $373,755, or $603,598 or $1.06 million to what you would have at age 70.

That’s the value of choosing a generous employer, so choose carefully.

And remember that the three figures I just reported resulted from only $1,500 a year for those early five years — $7,500 in total.

3. Diversify your investments

It’s no secret that over the long term (and 45 years certainly qualifies), other asset classes have outperformed the S&P 500 index.

U.S. small-cap value stocks hold the best record for beating the S&P 500. From 1970 through 2020, they achieved a compound annual growth rate of 13.5%.

For the five years of investments that we’re discussing, you can easily put that information to work for you. I suggest a 50/50 combination of the S&P 500 and small-cap value stocks. Over the 51-year period 1970 through 2020, that combination would have grown at an annual rate of 12.3%.

Applied to your own savings and your employer match, that asset combination would give you $65,285 by the time you’re 30.

And if you invested that amount at the S&P 500’s long-term rate of 11% for another 40 years, you’d wind up with $4.24 million at age 70.

But just for fun, let’s imagine that after five years, you are comfortable with this 50/50 combination of the S&P and small-cap value – and you continue it for the next 40 years. At the long-term growth rate of 12.3%, your $65,285 would become $6.75 million.

These projections are unrealistic – but not for the reason you think

I’ve just shown you three pretty simple steps to turn five years of $500-a-month savings into a multi-million-dollar nest egg.

But some people will criticize these numbers as very unrealistic. And that criticism is deserved. The reason: What I’m showing you is based on the assumption that you don’t save another dime for retirement after age 30.

In fact, it’s much more likely that you will continue saving, thus taking more advantage of that great gift of time.

As part of a smart investment strategy, you also should reduce your risk by putting other money into bonds. Talk to the financial firm handling your IRA or 401(k) or other financial pro about the right asset allocation for you.

Just for kicks, I wondered what the result would be if after age 30 you kept investing only half as much: $250 a month or $3,000 a year, with zero employer match, in the 50/50 combination of the S&P 500 and small-cap value stocks.

The result: $11.96 million at age 70.

I know what you’re thinking. And you’re welcome.

For a discussion of combining small-cap value stocks with the S&P 500, check out my podcast “The #1 two-fund equity portfolio.”

Richard Buck contributed to this article.

This article was originally published on this site