As we continue to learn more about the financial side of early retirement, we can quickly understand that saving and investing is a top priority. Your money today is worth a lot more to you in the future than it is now. Our money needs to work for us in order to… make more money! The reason for this is compound interest. We are specifically talking about your investment account growing larger as the interest earned is “re-invested”.
Think of it this way, you have decided to invest $100 that earns a compounded 10% interest on a yearly basis. After one year, your $100 has become $110- great work! Now you have a starting balance of $110 for year two. Now that 10% return will help you grow to $121 by year 2’s conclusion. We went from earning a $10 profit in year one to an $11 profit for year two. As you can imagine, these returns become much larger as your investment account balance grows. Let’s look at some bigger numbers and longer time-frames that relate to early retirement.
Say throughout the year you are fortunate enough to save $500 per month towards retirement. That would mean that you have invested $6000 towards your goal of financial independence. Let’s think about where we should put those savings. One option would be to place this $6000 in a standard savings account at a local bank. I looked at Bank of America for example, which is currently paying out a whopping .1% interest. This means that our $6000 would make us about $6. That is a financial disaster and your cash employees need to be fired immediately! By simply placing your cash into a standard savings account you are actually losing money because of inflation- (inflation is the general increase in the value of cash in the whole economy). Inflation is typically around 3% annually. The value of a normal dollar is going up 3% by existing, but your cash is standing on the sideline doing nothing. This is sadly the investment option that many uninformed people choose today.
Our next, slightly better option is a secured online bank like Ally.com. I personally use Ally for banking and endorse it. Due to their lower overhead business model, Ally is able to pay out a .99% interest rate on their online savings account. This means that our $6000 investment would earn roughly $60. This is a pretty dramatic improvement over the interest rate offered at our local, brick and mortar bank. However, we are still getting beat by inflation. Our cash is still a crappy employee that needs to be fired! An online savings account is not going to get us to our financial independence dream at all, but it is definitely a better option than the local standard savings account. It represents a no-risk “investment” that at least earns us something for our troubles. This makes Ally, or another high-yield online savings account, a good destination for our emergency fund or for liquid savings that are needed for a major purchase like a rental property. There are also old-fashioned investment routes like bonds and CDs. These offer a low interest and no-liquidity. They do not currently make sense for a person on a path to financial independence .
The final option we are going to review is the investing route. This means placing your savings in a taxable or non-taxable (IRA, 401K, HSA etc…) investment account that we invest in various mutual funds. This is where we can start earning some returns that will lead us on our path to real wealth accumulation. Over the past 30 years the average annual return of the S&P 500 is roughly 12.7% including dividend reinvestment. After we account for inflation that means we are profiting by 9.7%. We can reduce that further by assuming that we diversify our investments into bonds and having a slightly pessimistic/conservative outlook on the future of the market. Let’s use a cautious 7% adjusted annual interest rate for our $6000 investment. This would mean that in our first year, our little green workers would magically create 420 new friends. Our investment has quickly grown to a starting balance of $6,420 for year 2. What happens when we look at our $6000 over an even longer time-frame, like 15 years? It grows to $16,554! And what if we continue to contribute $6000 annually? We have $177,882.51 after 15 years, and would become millionaires after 36 years.
As you can see, the wealth accumulates faster over time. That first year, our $6000 earned us $420. By making the same annual transfers, our investment account earns us $17,637 by year 15. Our total annual savings contribution is still $6000, but because we have invested intelligently, our cash stash has grown immensely. This is the beauty of long term investing. For comparison, if we contributed the $6000 annually to our Bank of America account, we would only have $96,814. Our intelligent investing increased our wealth by more than $81,000 over letting our cash sit in a standard savings account.
I hope this case study shows the overall impact of intelligent, long term investing on retirement. Tell your cash to get off the couch and get to work!