Investing is a pretty complicated topic, and learning the basics is critical if you want to start on the path of a secure retirement. There are only a few concepts to master in order to gain a greater understanding of the many options available for saving money, so read on if you want to know the basics.
Do you think saving money is complicated? Grab an envelope, write Retirement Funds on it, and put in $20. Congratulations, you just saved $20 towards your retirement. It can’t really be that easy, can it? Well, no.
But now we can introduce a few other investing concepts. The first is risk. You want to make sure you have that $20 when you retire in the future, but many things could happen between now and then. If have $20 in an envelope, could someone steal it? Could you misplace it? Would it go up in smoke if your place caught fire?
The next up is taxes. You paid income tax on that $20. There’s nothing you can do about it, as taxes are a part of life, but it’s important to understand that in order to save that $20, you perhaps had to earn $30. When we talk about other types of investing, you’ll see why this is important.
The next concept is inflation. Inflation basically means that a dollar today will buy less than a dollar will tomorrow. Instead of thinking that inflation might average 2.5% a year, think about what you can buy for $20 today. Around me, that’ll buy about 8.8 gallons of milk, but in 30 years, it might only buy 4.2 gallons. You’d still have the same $20, it just wouldn’t buy as much.
If the envelope with your $20 is easy to get to, you might be tempted to spend it to order some takeout. Ease of access is another important concept to understand. In general, we think of cash as being liquid, you can instantly exchange a twenty dollar bill for $20 in goods or services. While liquidity can be a good thing, if you don’t have self-control, it can be a detriment to your retirement goals.
So you can see a few of the downfalls of putting $20 under your mattress. It won’t be worth as much later, you might spend it on something else, you might lose it, and you paid taxes on the $20. Let’s imagine though if you had a fireproof safe and promised not to spend the money on anything until you retire, what would a good retirement fund look like?
If you make $50,000 a year, and save 20% of your salary for 40 years, while getting a 2% raise every year, you’d have $604,019.83 stuffed in your safe. That probably sounds like a lot of money, because it today’s dollars, it is! But remember our nemesis inflation, and at 2.5%, in today’s dollars you’d have $224,955.48 40 years from now. I wouldn’t turn down $200k, but I don’t think I would be able to retire on it either.
So what other options are out there? Tons!
The most basic is a savings account. By moving your savings into a savings account, you might earn 1% interest on the money. 1% isn’t a lot, but it raises your 40 year ending balance to $726,368. There are pros and cons to moving your money here. While you’ll have $122,348.17 more than if you put the money under your mattress, you’ll also pay taxes on your earnings, and the money in your account was put there after taxes. On the flip side, you don’t have to worry about losing the money in a fire, though if the bank fails, you are only insured up to $250,000. You could get around that by just opening up another account at another bank if you believe a bank failure is a possibility.
While $726,368 isn’t bad, after 2.5% inflation, in 40 years it’s like having $270,521.69. Since most folks need more money than this to retire, we should look into other investments. When you invest, you typically are exchanging a higher interest rate for higher risk. What has the lowest investment risk? Typically bonds, which are IOUs usually issued from the federal government, state governments, local governments, and corporations, from least risk to most risk. It’s more likely that a corporation will fail than the federal government, in theory anyway!
Every month you could buy a bond, and then hold onto it and earn interest every year from your investment until the bond comes due. Imagine you give me $1,000, and I agree to pay you 4% interest every year for the money for 30 years, at which point I pay you back the original $1,000 you gave me. After 30 years you’ll have made $1,200 in interest, and get your original $1,000 back, for a total of $2,200. The longer the term of the bond, the higher the interest rate. The downfall is your money is tied up in the fund, so when you’re a month away from retirement, you probably don’t want to purchase another 30 year bond.
To get around this long-term investing issue, companies created bond funds, plus the option to buy and sell bonds on the market before they mature. Once you start talking about investments like this though, there are no guarantees. If you have a bond that pays 4% interest, and 5 years later I can buy a bond that is now paying 6%, why would I want to buy your fund? You’d have to sell it to me at a loss if you wanted to cash it out.
Historically, from 1928 to 2014, the 10-year Treasury bond has returned 5.28%. So if we repeat the investing scenario, with you making $50,000 a year, and save 20% of your salary for 40 years, while getting a 2% raise every year, and investing it in a 10-year Treasury bond, at the end of 40 years you’d have $1,804,936. After 2.5% of inflation, you’re talking about $672,213.44 in today’s dollars. That’s not an insignificant amount of money to retire on.
Still, you might envision cruises and fancy cars, so there must be a way to earn even more, right? Of course there is!
If you’re willing to accept more risk, you can potentially gain more reward. I’m not talking about going to Vegas and putting all of your money on black, though that certainly is an option! Instead, you can purchase stocks. Some stocks have performed amazingly well. If you bought $50,000 worth of Apple stock on January 1, 1990, you’d have $576,503.97 today. If you bought $50,000 of Enron stock on January 1, 1990, you’d have $0. This is where diversification comes into play. Just like bonds, you can invest in a group of stocks. So if you instead bought $25,000 of Enron, and $25,000 of Apple, you’d have $288,251.99 today.
One of the best ways to diversify is by investing in an S&P 500 index fund, which is a fund that buys a little of everything in the S&P 500. You can buy funds that cover just about anything, but I haven’t seen anyone go wrong with the S&P 500.
Even though on all of my calculations on this site I use a 7% return when calculating the return on the S&P 500, the actual average return from 1928 to 2014 is 11.53%. Using the same numbers as above, that would net you a total of $8,945,386 after 40 years, and $3,331,535.69 after inflation. If you can’t retire on that after living on an income of $108,237 (those 2% raises over 40 years added up), perhaps you need to investigate your lifestyle!
So what’s risk worth to you? Retiring on $3,331,535.69 by investing in the market, or $224,955.48 by saving it under your mattress?
From this simple introduction, there is no limit to the amount of knowledge you can gain on retirement topics. Invest in your 401(k) at work and you can invest pre-tax dollars in all of the types of funds mentioned here (cash, bonds, and the general market), and pay ordinary income taxes when you withdraw the money. Leverage an HSA and you can potentially invest tax-free and enjoy the returns tax-free. Invest in a Roth IRA and you can pay taxes now and withdraw the gains tax-free. Invest in a traditional IRA and your contributions are tax-free but what you withdraw is taxed at your ordinary income rate. Invest in the market using a brokerage account and withdraw your gains paying long-term capital gains tax.
Each strategy has its pros and cons. No one knows what taxes will be in the future, so maybe you invest as much as you can in a tax-advantaged account, a little in an account with capital gains tax, and a little in an account with ordinary income taxes. Perhaps you invest in an account you can get to your money easily if you intend to retire early, and in other accounts where you can’t be tempted to spend your money on a mid-life crisis. Maybe buy a rental property, or start a business.
The options are limitless, but you have to start somewhere, even if it’s just putting $20 in an envelope labeled Retirement Funds.