Good afternoon to all of you and a very special good afternoon to Eithne (pronounced Enya).
Last week, I answered some questions that a reader named Eithne had sent in about how best to roll over an old 401(k) to something that made sense in her new capacity as a freelancer.
In that post, I talked through some details of the SEP IRA and the One-Participant 401(k) to help her decide between her options and got her started on thinking about what to consider when putting together an investment strategy.
However, I unfortunately forgot one huge aspect. The most important thing about investing as a 25-year-old is to do whatever it takes to contribute as much as you can as early as you can.
Sure, you can invest at any point between now and when you retire, but you’ll never see this long a horizon for your contributions to grow and recover from any downturns in the market.
Let me see if I can explain better with an example.
An example (based on my life)
Part 1: The early investor
Suppose I had started contributing $4000 to a Roth IRA every year since I turned 25. Suppose further that I had put all of that into a broad-based index fund; in this example, I’ll use the Vanguard Total Stock Market Index ($VSTMX) mutual fund*.
After plugging in the values for VSTMX taken from Yahoo! Finance, it looks like taking this approach would have left me with $64,167 as of the market close yesterday. Not bad for putting just a few-thousand dollars away every year, right?
Now, look at the next line after that. What that says is that if I were to never make another contribution again, then the value of my Roth IRA would be a not insignificant $157,769 when I turn 65 and am ready to retire.
Part 2: The later investor
Now, imagine instead that I had done the opposite — that is, suppose I had put nothing away until this point and instead, planned to put $4000 into a Roth IRA for the coming 31 years until I turn 65.
If I had waited to put anything, then I would end up with $188,367.
What you should notice is that yes, I do end up with more in the second scenario — 19% more, in fact — but it doesn’t seem to be substantially more, even though I made over three times as many payments.
Let me say that again more clearly: Investing for 10 years now will give you almost the same result as investing for 31 years later.
And one more time a different way: Investing $40,000 over the next 10 years will give you almost the same results as investing $124,000 later.
Look at these two graphs:
What these graphs say is that when you invest later, you have to keep working hard to keep putting new money in. But when you invest early, the money you put in does the work for you, thanks to compound returns.
Before I conclude, there are a few assumptions I made here:
- I assumed that VSTMX would grow at a constant 8% annual rate; the market will likely not do this
- I did not adjust for inflation because I’m comparing final results at the same future date, however inflation may play an important role in how much you’re able to contribute
- I did not adjust the retirement strategy as age 65 approached; in practice, investors near retirement may change their investment mix or contribute more to catch up
Of course, what wold be even more ideal would be to both invest now and invest later.
Good luck, Eithne
*Important disclaimer: Do not take my use of this fund in my example as an endorsement of this fund, the fund family, or any implied investment strategy