Putting Einstein to work for your investing future
Reprinted courtesy of MarketWatch.com.
To read the original article click here
No matter what your age, or how much or little money you have, you can put one of Albert Einstein’s insights to work for you. That’s a very smart thing to do, and I’m going to show you how.
This is the second part of a series on compound interest, which was famously cited by Einstein as one of the wonders of the world. You can read the first column here.
In my previous column, I showed how the formula works over a variety of time periods (20 years out to 100 years) and for five compound rates of return that are reasonable for investors to expect, depending on how much risk — or how little risk — they decide to take.
To reiterate what’s obvious to anybody who has thought about it, higher long-term results come from longer periods and from higher rates of return.
The tables I cited show the hypothetical growth of $1,000. At the shortest and most conservative end, that sum grows to $2,191 when invested for 20 years at 4%. On the other end, $1,000 grows to $83.5 million when invested at 12% for 100 years.
For most investors, somewhere in the middle of those extremes is much more likely. So that’s what we’ll focus on here.
We will look at three hypothetical investors: one is a 25-year-old person starting a career with enough income to set aside $5,000 a year. The second is a 45-year-old person who has saved $120,000 and continues to add $5,000 a year. The third, a 65-year-old new retiree who has a $1 million portfolio and expects to live another 30 years.
The 25-year-old woman
Young investors have an extremely precious resource: time, which works wonderfully with compound interest. However, setting aside money when you’re young isn’t necessarily easy. Student loans, new households, growing families, and day-to-day living all have important claims on a young person’s income.
But the tables from my previous article show what’s possible. Let’s assume a 25-year-old invests $5,000 (only once) in equity funds and earns 10% over the years. At age 65, her single $5,000 investment will be worth $226,295.
Lesson: Even a relatively unspectacular return like 10%, if it’s given lots and lots of time, can produce amazing results.
After 40 years of putting in $5,000 a year and earning 10%, she would have about $2.21 million.
For this example, I chose 10% because history suggests it’s reasonable to expect that from investing in only the S&P 500 Index. In my prior column, I suggested 12% is a quite reasonable expectation for somebody investing in small-cap value stocks for the long haul.
If this woman put half her money in the S&P 500 and the other half in small-cap value, she might earn 11%. At that rate, her first $5,000 investment would grow to be worth $325,004 instead of “only” $226,295. That extra amount, by the way, is nearly 20 times the original number of dollars she invested.
And at age 65, if she did that for 40 years, she’d have a portfolio worth $2.9 million.
The 45-year-old investor
Now think of a 45-year-old investor who has a portfolio worth $120,000 and is adding $5,000 a year until he’s 45. If he invests the $120,000 in a way that earns 10% a year, that nest egg would grow to be worth $807,300 by the time he’s 65.
Starting at age 45, let’s imagine a second “pot” of money into which he puts $5,000 a year. Assume this one is fairly conservative, earning 7% and giving him a growing cushion of bond funds for protection from market volatility. Twenty years of those contributions, at 7%, would be worth an additional $204,977. Total portfolio: $1,012,277.
(I want to emphasize, by the way, that these examples are not recommendations for asset allocations. I use them only to show how compound interest can work well over time.)
The 65-year-old person
A 65-year-old who retires with $1 million has multiple options for withdrawals, and I can’t get into these details here. But if she’s going to live another 30 years, she will need some asset growth to try to keep up with — and ideally ahead of — inflation.
The following idea won’t fit everybody, and it’s not a recommendation. But I think it illustrates what’s possible you think of a portfolio as having separate components that are designed to do different jobs.
This 65-year-old woman could invest $900,000 of her $1 million in a 50/50 equity/bond portfolio and take out $40,000 a year (adjusted each year to keep up with inflation) with little risk of running out of money. That’s a withdrawal rate of 4.5%, which is pretty reasonable, especially considering what she could do with the remaining $100,000.
Let’s say she invests that last $100,000 in a small-cap value stock fund and plans to leave it there for at least 20 years. At 12%, it would grow to be worth $964,629.
That would provide her an ample supply of “rainy-day” money in case she needs it. If she’s still healthy and spry at 85, she could really live it up with that much money.
If she doesn’t use the money herself, it’s a terrific legacy for her kids, grandkids or any other beneficiary in her will.
This scenario might be a bit extreme for many retirees, and I am not necessarily recommending it. Bur I think it’s useful to see some of the projections you can make if you understand compound interest and put it to work for you.
Before you rush out and put your money in small-cap value stocks, remember that I want you to be as smart as Einstein. So I hope that you’ll read my next column, in which I will discuss this asset class in some detail and why I think it could play a valuable part in just about every portfolio.
Richard Buck contributed to this article.