Financial Freedom

Blend three ingredients — a paycheck, discipline and time — and, you, too, can be a millionaire. It’s not always easy, but it’s simple. And you have no excuse not to do it.

By Harry Domash

Here is the single most important thing you will ever hear about investing: Getting rich is simple.

Not easy, but simple.

And here is the second most important thing you will ever hear about investing: You have no excuse not to do it.

Only three ingredients are needed: income, discipline and time. Chances are, you already have two of them, income and time. All you need to do is add the third, discipline. And armed with the following knowledge, that key third ingredient may be a lot easier to find.

Here’s how it works: Say you start with nothing, invest $500 (of your income) a month (a healthy discipline), and let your money ride (over time) in diversified investments. Long term, the stock market returns at least 10% annually. Assuming a 10% return, you’d have $102,000 after 10 years, $380,000 after 20 years, and $1.1 million in 30 years.

Here’s a similar scenario: If you start with a nut of $50,000 and add only $250 per month, you’d have $180,000, $516.000 and $1.4 million after 10, 20, and 30 years, respectively. All this happens through the power of regular investing and a simple-but-powerful concept called compounding.

Compounding

What is compounding?

Compounding is the reinvestment of the interest you receive from the money you set aside. For example, if you invest $1,000 and earn 10% interest on your principal at the end of each year, you’ll get in $100 interest at the end of the first year. If you reinvest that interest, the second year you would start with $1,100, and thus would earn $110 interest. If you stay with it, you’d more than double your money every eight years.

“Compounding,” Albert Einstein said, “is mankind’s greatest invention because it allows for the reliable, systematic accumulation of wealth.” Einstein was a smart man. But you hardly have to be a genius to make this concept work for you.

The real magic of investing comes when you combine the surprising power of compounding with continuous and regular investments — in other words, discipline.

The best way to make these continuous investments happen is by setting up an account with a broker or mutual fund that automatically deducts a fixed amount from your bank account every month.

“Automatic” is the operative word here. Trust me, if you don’t set it up that way, it won’t happen. Instead, you’ll end up pouring money in when the market is soaring and skipping payments when it’s heading down. Eventually you’ll get discouraged and give up.

Dollar-cost averaging

The process of continuously investing a fixed dollar amount is called dollar-cost averaging — a term that sounds much more technical than it is. Through dollar-cost averaging, you’ll end up buying more shares when a stock or fund is down, and fewer when it’s up. For instance, say you’re investing $500 monthly in a stock trading initially at $50 per share; so the first time, you buy 10 shares. If the next month the stock moves up to $62.50 your regular purchase will net you only eight shares. However, if the stock drops to $41.67, you’ll get 12 shares (not including any transaction fees).

It’s easy to set up regular-investment mechanisms, thus harnessing the power of dollar-cost averaging. Mutual funds are the traditional way. But there are other outlets, as well, that allow you to apply the strategy with individual stocks or exchange-traded funds, which are baskets of stocks that identically track standard market indexes, such as the Dow Jones Industrial Average ($INDU).

Risk

Sure, investing in the stock market has risk. There’s always the chance the market will go nowhere for the next 20 or 30 years and you’ll end up no better than where you started. But there’s risk in everything, even CDs.

With CDs, your original investment isn’t in danger. Most CDs are insured, and the federal government will step in and make you whole, even if your bank goes belly up.

But a problem crops up when something more sinister surfaces: inflation. At this writing, inflation, running at around 2%, is considered relatively benign. But is it?

Let’s do some math. Your real return is the interest you receive less the inflation rate. If your CD is paying 3% and the inflation rate is 2%, you’re only making 1% in real terms. If inflation takes off, say to 5%, your CD will probably be paying around 4%. In inflation-adjusted terms, you’ve lost 1%.

But it can get worse. Inflation hit 14% in the early 1980s. In such times, CDs and similar fixed-income investments don’t even come close to the inflation rate, meaning you’re losing serious money, in real terms.

By contrast, assets such as real estate and stocks tend to move with prices, and, over time, the stock market has outpaced inflation. For instance, in the 20-year period ending Dec. 31, 2001, the cumulative return of the market, as measured by the S&P 500 Index ($INX), was 1,606%, compared to 88% cumulative inflation over the same period.

What’s the point? Yes, there’s risk in investing in the market, but the odds are that continuous, regular investing combined with the power of compounding will make you rich.

The odds

If you count yourself a member of the “I want it now” generation, the idea of waiting 20 or 30 years to get rich probably sounds like a dumb idea.

Sure, there are faster ways to get rich. You could win the lottery, or pick the next Intel (INTC, news, msgs) or Wal-Mart Stores (WMT, news, msgs). But don’t quit your day job just yet. Your chances of winning big in the lottery run around 15 million to 1, at best.

Meantime, naturally, you would be sitting pretty if you had had the foresight to plunk significant cash into Intel or Wal-Mart 20 years ago. But consider this: You would have lost money if you’d picked Advanced Micro Devices (AMD, news, msgs) instead of Intel, and you’d be broke if you’d picked Kmart (SHLD, news, msgs) (which ended up merging with Sears Roebuck) instead of Wal-Mart. In both instances, your retirement plans would be history.

Here’s the bottom line, like it or not: The fate of your retirement, your comfort in older age, probably lies in your commitment to the concepts laid out in the paragraphs above. For the vast majority of us, wealth creation is a slow and steady — and powerful — process. The tortoise almost always beats the hare.

It’s not easy. But it’s very, very simple.

At the time of publication, Harry Domash did not own or control shares in any of the equities mentioned in this column.

Domash publishes the Winning Investing stock and mutual fund advisory newsletter and writes the online investing column for the San Francisco Chronicle. Harry has two investing books out, the most recent being “Fire Your Stock Analyst,” published by Financial Times Prentice Hall.

Be aggressive with your investments

Make sure to invest your money shrewdly. According to Hewitt, workers 18 to 25 typically invest 35% of their retirement savings in bonds. Yet bonds have historically returned 5.4% a year — right around the risk-free rate and just ahead of inflation. That’s practically sticking it in a jelly jar! Stocks, meanwhile, traditionally have grown at an annual clip of 10.4%, according to Ibbotson Associates, an asset allocation service that’s part of investment ratings agency Morningstar.

Instead, play it aggressive, and put 90% of your investments in stocks, says Ellen Rinaldi, executive director of investment planning and research at mutual funds giant Vanguard. Stocks are interchangeably referred to as equities, since as a stockholder you own a slice of the company’s value in the market, its equity.

“From an allocation viewpoint, someone in their 20s has a very long horizon, so they can handle the ups and downs of the market,” says Rinaldi. “They can recover from a downturn. As a result, they should be heavily invested in equities.”

You can hedge against the risk of loss by diversifying your investments. That’s a fancy way of saying you want to own as many different types of stocks as possible, and it’s a message that will hold true throughout your lifetime. That means steer clear of buying a single stock and look to mutual funds, a tradable vehicle made up of sometimes hundreds of different investments in widely varying quantities. They could be made up entirely of stocks, bonds, a combination of both or simply track the market by holding equal amounts of all shares in a given index, known as an index fund.

So-called lifestyle or life-cycle mutual funds make it especially easy for novice savers to buy a diversified array of stocks that are tailored to their age and retirement goals. That’s because these funds are set up to automatically pick and choose the equities in the fund, and to rebalance those holdings over time, buying and selling shares in order to maintain the advertised mix of risk and return (or caution and predictability) by age bracket.

“Look for retirement funds targeted to your age bracket. They’ll be much more aggressive for someone in their 20s,” says Rinaldi. “If you just look for a balanced fund, you may wind up with 40% of your money in bonds, which is a typical mix for these funds.”

Get educated

Meanwhile, don’t be embarrassed to admit that financial talk can seem confusing. After all, financial know-how is not genetically encoded and, unless someone has taken the time to teach you about finance, you’ll need to do a little learning. And now that you’re starting to make and save money, this is the perfect time to educate yourself.

More than a third of companies now offer employees access to advisers who can help choose investments that will be most appropriate, according to Hewitt. These advisers can explain what holdings are in a particular fund and why they’d recommend one investment over another. Read books, articles or financial Web sites. The more you know, the easier it will be throughout your career to make solid, informed decisions.

“I think the reality is most parents are more inclined to talk to their kids about sex education than talk to them about finance or saving for retirement,” says Jones. “That’s just not a conversation people have, so a little Finance 101 is probably a good idea.”

Build a strong defense with an emergency stash

What’s next? Start amassing an emergency fund so you don’t have to rely on credit cards — and possibly bury yourself in debt — in the event that your car dies, your roommate comes up short on rent or you suffer some other financial mishap. Ideally, you’ll stash up to three months living expenses, but the important goal is to save something. You can help stay on track by having automatic deposits made to your emergency account.

In the meantime, keep an eye on spending. Those splurges can add up fast and will prove to be a huge drain on future savings. What’s more, if you pile on debt, you’ll wind up wasting a lot of money on interest and fees that could be better spent elsewhere.

Avoid debt

If you’re really struggling to stretch the paycheck to set something aside for retirement, this is the time to make some changes.

Give your budget needs a major overhaul. Consider getting a roommate or picking up an extra job for the time being. Big changes now, coupled with consistent saving over time, will reap huge rewards down the road, says Jones. He speaks from experience. Jones took a year off from college to work so he could pay off credit card debt. It wasn’t easy but, he says, “I graduated debt-free.”

Lamb has already seen how a little financial discipline reaps big rewards.

“Making my bills is my No. 1 priority before anything else. I don’t buy new clothes. I cook at home. And I don’t drink, which is a big money-saver. People go out and will spend $100 on alcohol in one weekend. I don’t do that,” she says.

Yet she does let herself have occasional “big purchases,” like a house recently bought with her fiance.

“I really wanted one,” she says. “And I made it my goal.”

This article was reported and written by Leslie Haggin Geary for Bankrate.com.
Published May 25, 2007

Even if money is tight, this is the time to start stashing away money. Start small, start now.

By bankrate.com

It’s easy to understand why retirement doesn’t loom large on the horizon for 20-somethings. Young workers are more concerned with kick-starting careers, not ending them in the long-distant future.

But it’s worth noting that the very fact that you’re young gives you a huge edge if you want to be rich in retirement. That’s because when you’re in your 20s, you can invest relatively little for a short period and wind up with far more money than someone older who saves much more over a longer period.

Consider this scenario: If you begin saving for retirement at 25, putting away $2,000 a year for just 40 years, you’ll have around $560,000, assuming earnings grow at 8% annually. Now, let’s say you wait until you’re 35 to start saving. You put away the same $2,000 a year, but for three decades instead, and earnings grow at 8% a year. When you’re 65 you’ll wind up with around $245,000 — less than half the money.

Seems like a no-brainer, right? Save a little now and reap big rewards later.

Unfortunately, many of today’s youngest workers pass on the opportunity to save for retirement early, when the beauty of compounding interest can work its magic and maximize savings. A recent study by human resources consultant Hewitt Associates found that just 31% of Generation Y workers (those born in 1978 or later, now in the thick of their 20s) who are eligible to put money into a 401(k) retirement savings plan to do so. That’s less than half of the 63% of workers between ages 26 and 41 who do invest in employer-sponsored savings accounts.

Start saving ASAP

There are plenty of reasons you may have yet to save, such as cash flow. If you’re struggling to pay off student loans or cover rent, funding a 401(k) may seem difficult if not downright impossible.

But be wary of letting expenses become an excuse, says Brian T. Jones, a certified financial planner and the author of “Getting Started: The Financial Guide for a Younger Generation.”

“These years of saving in your early 20s are your prime years. If you deny yourself the opportunity, it will just set you back with retirement planning in the long run,” says Jones. “You’ve got to have balance.”

Sign up for that 401(k)

Make the most out of those few dollars you can get hold of by allocating them wisely. Don’t squirrel them away under the mattress. You will want them to be invested in a way that will encourage your assets to grow as quickly as possible.

Where to start? If you’re eligible to participate in a 401(k) at work, do so. There are plenty of reasons to love these plans but No. 1 by far is that most employers match your contributions in order to encourage your participation. The hitch: Oftentimes, you’ll need to save enough to trigger the match.

In a typical plan, employers match up to 3% of your salary, according to the Profit Sharing/401(k) Council of America. When you do sign up, the money you save will be automatically deposited into the plan before it’s taxed, so less of your income will be taxed now. That saves you money, too.

That’s what Rebecca Lamb has discovered. The 28-year-old Connecticut resident works in a nonprofit organization so she saves in a 403(b), which is similar to a 401(k) though they often don’t allow company matching. These days, Lamb can’t afford to plow huge sums into the plan, but she saves what she can. She also has a savings account that she opened when she got her first job at 15.

“I’m a disciplined person. I put in little amounts and save what I can. If it’s $20, I put that in. If it’s $100, I put $100. I’ve always done that,” she says. “I’m just trying to save what I can right now. Hopefully, in years to come, I’d like to think I could put more way. But right now I’m just trying to save what I can because every little bit counts. I don’t get caught up in the numbers.”

No company retirement fund?

Use a Roth instead If you aren’t eligible for a retirement fund at work that gets you matching funds, sign up for the next best thing: a Roth IRA. You’ll fund this with money that’s already been taxed as part of your normal paycheck. But money in a Roth IRA withdrawn later is tax-free.

This year, you can put up to $4,000 in a Roth, but don’t let that number scare you off if it seems far too rich for you today. Save what you can. It will add up. If you are able to sock away $4,000 a year into a Roth for 40 years, and if it earns 8% annually, you’ll be a tax-free millionaire at retirement.

To make sure you stick to saving, have a portion of your paycheck or payments from your bank account automatically deposited into the Roth each month or every few weeks.

The government puts inflation rate at 3.2% to 4.8% but in urban areas, that figure is about 6%.

Today, three meals cost about RM20 but in 20 years time – with an inflation rate of 6% a year – we will need RM63 per day for the three meals.

So while the RM500,000 in your EPF or bank account at retirement might look good on paper, if you do not invest that money to make it grow at a rate higher than the inflation rate, 20 years later, it would be worth only RM145,053 in purchasing power!

Reality hits when people find that they cannot afford to retire because they had not seriously put aside the money early on in life.

“It is more pleasurable to spend than to save”

People understand – at head level – the need to plan and save, but at heart level, emotions rule and instant satisfaction wins the battle.

A noticeable trend is that while the younger generation is prepared to invest in new financial instruments, the older generation gravitates towards fixed deposits. That is very risky because you would not be able to accumulate enough because the interest rates cannot meet the inflationary rate and your money is getting smaller.

The Story Of Bonnie And Clyde

The earlier you start saving, the less you need to save and the more you will get.

Bonnie started saving at the age of 18. Every year, she allocated RM1,000 into investment fund. She does this throughout 10 years till she reaches age of 27 and no further.

 

Clyde started saving only at the age of 27. Every year, he allocated RM1,000 into investment fund. He does this throughout 29 years till she reaches age of 55.

By the age 55, Bonnie would have accumulated RM252,772 in savings assuming that the growth rate of 10% per year. She only invested RM10,000. Profit of 25.27 times.

However, Clyde only accumulated RM163,475 in savings assuming the same growth rate. He need to invest RM29,000. Profit of 5.63 times.

The difference between the two is very significant. Therefore, it’s up to you to choose whether you want to be Bonnie or Clyde. Bonnie is definitely my choice. This really gives a big impact and we should be more conscious and start saving immediately.