I wanted to write about investing today but decided not to. Instead, I will share one more example to illustrate the partnership between saving and investing. This post is similar to an earlier one titled “The math of growing wealth“. My next post will be about comparing investments.
One of my friends is a retired investment advisor. In a presentation, he emphasized: Start investing early. He illustrated this with an example of two imaginary people, Amy and Bob. They both get jobs at the same time, and both work for 30 years before retiring. Amy saves and invests $10,000 each year for the first 10 years of her life. She then saves no more but keeps her money invested. Bob, on the other hand, saves nothing for the first 10 years, but saves and invests $10,000 each year from year 11 through year 30. At retirement, Amy, who saved for only 10 years, has more money than Bob, who saved for 20 years. If investments grow at 8% each year, Amy has $675,212 whereas Bob has only $457,620. This is true even though Bob saved for twice as many years. Moral of the story: Start saving and investing early.
But why does Amy have more? To answer the why, it helps to understand how money compounds over time. The charts below show the net worths of both individuals over the years. Net worth is divided into two parts: one part that can be attributed to savings accumulated over the years, and another attributed to accumulated investment income. Cumulative savings (in blue) and investment income (in red) are shown as stacked bars for Amy and Bob in the two charts below.
A few basic observations are presented below:
- Amy’s savings start from $0 and grow to $100,000 in the first ten years. Her cumulative savings don’t grow after that. However, her investments continue to grow.
- Amy’s investment income is relatively modest in the first ten years. She saves a meaningful $100,000, but her investment income adds up to only $44,866 over these ten years. Compare this with the last year of her career, when in that one year alone her investment income is $54,017, more than in the first ten years combined.
- Bob saves nothing, and consequently has no investment income in the first ten years. His net worth is zero until year 10. From years 11 through 20, his wealth grows exactly as Amy’s grew in years 1 though 10. But then there is a departure. Bob continues to save, whereas Amy stops saving after the first 10 years.
Sadly for Bob, he still falls short despite saving for twice as many years. Saving is hard. It involves sacrifice. Why does Bob fall short? This question can be answered by looking at year 11. In year 11, Bob saves $10,000. Amy saves nothing. But Amy’s investments earn $12,516. Amy’s investments are growing faster than Bob can save! Amy had a huge head start. Even though her investment income seemed small in the first 10 years, the total pile of savings and investments she built in those early years was enough to outpace Bob. In year 30, Bob’s investment income is $36,610, which isn’t small, but it is well short of the $54,017 Amy’s investments earn in that year. For savers, investment income becomes sizable as they approach retirement, as it should be.
My friend, the retired financial advisor, lamented that his parents hadn’t invested their money in stocks. They had government jobs. They didn’t earn much. They had to save painstakingly to retire. But despite everything, they retired. They did one key thing right. They saved. They also bought a house to live in, which made them real estate investors. * All considered, they did better than most.
*On the point of whether the purchase of a primary residence counts as real estate investment, there is some disagreement (e.g., in the book Rich Dad, Poor Dad). There shouldn’t be. Buying property and becoming a landlord who rents it to others is purely investment. Like all investment, it carries risks. Renting a home from a landlord is purely tenancy, which is a form of consumption. Buying property to live in is a simple combination of these two. Because the owner is both the landlord and the tenant, the rent does not change hands, but its economic consequence surely exists. Therefore, a person who buys a home and lives in it is part real estate investor and part tenant.
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