When you’re young, retirement feels like a distant horizon, a far-off point in life that doesn’t require immediate attention. But here’s the truth: the decisions you make now about saving for retirement will have a profound impact on your financial future. The sooner you start contributing to a retirement account, the more you can harness the power of compounding returns and the time value of money. Let’s break down why this is so important and how starting early can set you up for a comfortable retirement.
The Magic of Compounding Returns
Albert Einstein reportedly called compound interest the “eighth wonder of the world.” Whether he actually said this or not, the sentiment is spot on—compounding can be incredibly powerful, especially when given time to work. Compounding occurs when the returns on your investments generate their own returns. Essentially, you earn interest on your interest, and this snowball effect can lead to exponential growth over time.
Example of Compounding:
Imagine you invest $1,000 at age 25 in a retirement account with an average annual return of 7%. By the time you’re 65, that $1,000 would grow to nearly $15,000, thanks to compounding returns. Now, if you waited until age 35 to invest that same $1,000, it would only grow to about $7,600 by the time you’re 65. That 10-year delay costs you more than half of your potential growth!
The key takeaway here is that time is your most valuable asset. The earlier you start, the more time your money has to compound, and the less you’ll need to save later in life to reach the same financial goals. To further illustrate the importance of early investing, review Total Wealth Planning’s “How Powerful Can Your Invested Dollars Be” document by clicking here. The document illustrates the “Multiplication Potential” of investing just $1 at a given age. If we use the information listed in the example above and apply this to the “How Powerful Can Your Invested Dollars Be” document, investing $1,000 at the age of 25, has a multiplication potential of 15.52. Meaning the initial $1,000 investment has potential to grow to $15,520 by time you reach retirement age. Now, if you waited until age 35 to invest that same $1,000, the multiplication potential falls to 6.99. What could have been a $15,520 investment balance if invested at age 25, falls to a value of $6,990 when waiting to invest until age 35.
Understanding the Time Value of Money
The time value of money is a core concept in finance that states a dollar today is worth more than a dollar in the future. This principle is based on the potential earning capacity of money. If you have $1,000 today and invest it, that money can grow over time. However, if you wait and receive that $1,000 in the future, you lose the opportunity to earn returns on it during that waiting period.
Why Does This Matter for Young Investors?
When you’re young, you have a long-time horizon before retirement, which means that the money you invest today can grow significantly by the time you retire. Delaying your investments, on the other hand, reduces the time your money has to grow, and you’ll need to save much more later on to achieve the same financial security.
The Importance of Investing in the Market
Many young people are hesitant to invest in the stock market because of perceived risks. While it’s true that markets can be volatile, historical data shows that over the long term, the stock market has consistently outperformed other types of investments, like bonds or savings accounts.
Investing in a diversified portfolio of stocks through a retirement account, such as a 401(k) or IRA, can offer the growth potential you need to outpace inflation and build wealth over time. Since you have decades before you need to access your retirement funds, you can afford to take on more risk now, which historically has led to higher returns.
Example of Market Growth:
Let’s say you start investing $200 a month at age 25, and your investments grow at an average annual rate of 7%. By the time you’re 65, you could have around $500,000. If you wait until age 35 to start, even though you’re contributing the same $200 a month, you’d only end up with about $245,000 by age 65. That’s more than double the amount simply because you started 10 years earlier.
Practical Steps to Get Started
- Open a Retirement Account: If your employer offers a 401(k) with a matching contribution, take advantage of it. It’s essentially free money. If not, consider opening either a Roth or Traditional Individual Retirement Account (IRA).
- Automate Your Contributions: Set up automatic contributions to your retirement account from your paycheck or bank account. This helps ensure consistency and takes the guesswork out of saving.
- Increase Contributions Over Time: As you advance in your career and your income grows, try to increase your retirement contributions. Even small increases can have a significant impact over the long term.
- Diversify Your Investments: Don’t put all your eggs in one basket. A diversified portfolio reduces risk and can improve your chances of achieving steady growth.
- Stay the Course: The market will have ups and downs, but staying invested and not trying to time the market is crucial. Remember, time in the market is more important than timing the market.
Conclusion
Starting early with retirement savings allows you to take full advantage of compounding returns and the time value of money. The earlier you begin, the less financial pressure you’ll feel later in life. By contributing regularly to a retirement account and investing in the market, you’re setting yourself up for a financially secure future. Don’t underestimate the power of starting now—your future self will thank you.
About the Author
Keenan Garvey is a Financial Planning Associate with Total Wealth Planning, a fee-only fiduciary financial planning firm in Cincinnati (Blue Ash), Ohio. He is grateful to serve others, including his team of CERTIFIED FINANCIAL PLANNER™ practitioners and the clients they serve, so they can live their greatest life through well informed and prudent financial decisions. Keenan can be reached at keenan@twpteam.com