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Retirement 101–The Basic theory

Save early and save often.

  There is no time like the present!

The best time to plant a tree is 20 years ago….

 

History Lesson: Upon his death, Ben Franklin gave money to both Boston and Philadelphia with the condition that neither city spends the money for 100 years. Why? Because he wanted to let compounding do its thing.

 

Retirement planning Keys:

  • Save Early Save Often-set aside regular amounts every month
  • Earn a high return-take some risks
  • Reduce Tax bite! Don’t give the IRS anything that you do not need to!
  • Set aside enough that you don’t need to worry if your returns are lower than expected.
  • Do NOT forget about inflation.

 

One of the most important things anyone can do is to begin saving early, the earlier the better. This gives the money time to work for you. This is called compounding.  Compounding is when your interest (or other return but for now we will keep it simple) earns interest.

To appreciate its importance, consider the following example. Suppose you and your evil twin are both 25 years old and both plan on retiring in 40 years. As a FinanceProfessor student you realize that saving early is important. You decide to invest $2000 a year into a tax deferred investment that will earn 12% per year (which is roughly what the S&P has averaged for the last 60 years or so)

While you are a good investor and investing regularly,  your evil twin claims to have no money (although you both earn the same amount) and continues to live his free spending ways.

At the end of 40 years, presuming you stick to your plan and do not touch your investments, you will have $1,534,180 in your account (we will show how to calculate this in a little bit).

Eventually, after your prodding for 10 years, your evil twin decides to start saving as well. At this point, you are both now 35 years old (he is a few minutes older than you).  As twins have no secrets (I wonder if that is really true), you tell him how much you will have and he wants to have the same amount.   So he decides to catch up so that at retirement (now 30 years off), you will each have the same amount.

 He asks you to determine how much he will have to save each year to have as much as you. You check with your FinanceProfessor.com and find the somewhat shocking answer: $6,357!   Over three times the amount that you have to invest each year!

 Can you do the math?  You definitely should be able to for the test!

Why does he have to save so much more? Because you have your money compounding for a longer period of time. Thus your money is working for you. Work smart, start early!

Now we have cut some corners in this example, but the idea is the key thing: over the course of the 40 years you will have invested $80,000 while your brother will have invested over $190,715.  Hopefully, this example will motivate you to begin saving as early as possible!

Even if you do not have 40 years to retirement, the same idea holds true.  You may need to invest more than the numbers in this example, or may not end up with quite as much at retirement, but you will still be better off if you do not put off your investments any further.

Now is the second best time to plant a tree, the best was 25 years ago–a Japanese proverb. O

Of course the problem is that now is not when we want to start saving.  Oh, sure now is the best time to save, but now is also the time when we have a million things we would rather do with the money rather than saving it. Or we may be short on funds, or just do not want to put up with the hassle sometimes required to invest.

So how do we start? My advice is to save a little bit on a regular basis. Many mutual funds have automatic investment programs. These investment programs regularly, and automatically, take small amounts of money from your bank account to invest. The advantage of these programs is that once they are set up you do not need to think about it. The investment becomes automatic which takes you out of the picture, and thus you do not have the opportunity to give in to the temptation of putting off savings. (And trust me, you really will not miss the money after a few months.)

Now before you invest immediately, there are a few more things you should know, but let’s make the goal of starting this week. Once you get your investment plan underway, you can largely put in on auto-pilot. Do not worry about day-to-day price swings. Rest assured that in the long run you will be better off sticking to your game plan than constantly fretting and moving your money from one investment to the next. It is a good idea to make additional investments into your account whenever you are able. This may be when you get a bonus, or merely when you have saved up some extra money. On the other hand, when you get a raise or finish paying off a debt, contact all the mutual fund and raise the automatic investment amount. Additionally you should make sure to always reinvest your dividend payments.

One important issue that still needs to be discussed is what assets you should invest in. Historically stocks have outperformed other investment opportunities. Although this is no guarantee that stocks will continue to outperform other assets, most will agree that for the long run, stocks are where money should be invested.  However, as investors get closer to their retirement, the percentage of wealth invested in stocks should be reduced.  Historically there has been a rule of thumb that you should invest 100% minus your age in the stock market and the rest between government securities, cash, and corporate bonds. However, with longer life expectancies this is probably too conservative. Indeed, if you are a long ways from retirement you may want to be fully invested in stocks and even in retirement, you should probably keep 50-70% of your money in higher returning assets (such as stocks).

A friend of my Zvi Bodie has convinced me that a mix of Treasury Inflation Protected Securities and Long term Options on the Market is a good way to more or less have your cake and eat it too.  It guarantees a lower bound to live on, and if the market does well, so does your portfolio.

A final point:
Taxes can take out a big portion of your returns.  To prevent this necessitates a well laid out plan.  The general rule is to make use of any tax-advantaged plan that is possible and recognize profits as infrequently as possible.  This means investing through company sponsored plans such as a 401(K) as well is investing in IRAs. Also look for funds with low turnover and low expenses.

 


 

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