May 28, 2019 The Huge Cost of Doing Nothing
One of the biggest decisions when transitioning into adult life is when to start saving. Putting off savings till later comes with a cost of waiting. Cost of waiting describes the opportunity cost when an individual decides to wait before beginning to save money. This cost can result in a smaller portfolio at retirement, larger contributions later in life to catch-up, or a lower standard of living.
Savings should be compared to running a marathon. The sooner you get started, the better off you will be reaching the finish line. By starting to save early in life, you gain an overwhelming advantage over those who wait later due to the time value of money. Time value of money is an essential component of finance. “A dollar today is worth more than a dollar tomorrow.” A dollar received today is worth more because that dollar can be invested, earn interest, and eventually compound in value. It has an opportunity value that a dollar tomorrow doesn’t have.
A quote commonly attributed to Albert Einstein says that “Compounding interest is the eighth wonder of the world.”
Compound interest can be extremely powerful for investors over time. Compounding interest essentially results in interest on interest, and it’s why so many long-term investors have been successful.
To demonstrate this, consider the fate of three investors. John, Bob and Mary. Each have a hypothetical 6% return (compounded monthly) and 40 years to save for their goal. For the sake of simplicity, the effect of taxes is ignored on this example.
At the age of 25 John starts saving for retirement with the plan to retire at 65. If John contributes $6,000 per year ($500 per month) into an account every year for 40 years by time John is 65 he has accumulated almost one million dollars ($995,745).
Now let’s look at it from an individual who decides to wait. Bob decided to wait on putting money aside until age 45. He was busy getting his career and family started. However, but has more disposable income so he can start putting away $1,000 per month. Over the next 20 years Bob will save the same amount of money as John ($240,000) but only accumulate $462,040 towards his goal.
Lastly, let’s look at an individual who starts saving early and then stops. Mary starts saving to her savings account at age 25 with the goal of retiring at age 65. However, Mary’s financial priorities change, and she stops saving at age 40. She has only saved $90,000 towards her goal but will still have 45% more saved than Bob. Her account balance of approximately $649,248 takes advantage of compound interest over the entire 40-year period.
The moral of the story is that it pays to start saving as early as you can. It is worth much more than waiting to save more when your income is higher.
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