Saving dominates initially. Investing later.

One of my friends is a retired investment advisor. In a presentation, he emphasized: Start investing early. He illustrated this with an imaginary example of two people, Amy and Bob. They both get jobs at the same time, and both work for 30 years before retiring. Amy saves and invests $10,000 each year for the first 10 years of her life. She then saves no more but keeps her money invested. Bob, on the other hand, saves nothing for the first 10 years, but saves and invests $10,000 each year from year 11 through year 30. At retirement, Amy, who saved for only 10 years, has more money than Bob, who saved for 20 years. Assuming that investments grow at 8% each year (for simplicity) Amy has $675,212 whereas Bob has only $457,620. This is true even though Bob saved for twice as many years. Moral of the story: Start saving and investing early.
But why does Amy have more? There’s an important insight to be gleaned from understanding why the early years are so important. To answer the why, we must observe the how – how money compounds over time. The charts below show the net worths of both individuals over the years. Net worth is divided into two parts: one part that can be attributed to savings accumulated over the years, and another attributed to accumulated investment income. Cumulative savings and investment income are shown as stacked columns for Amy and Bob in the two charts below.
AmysNetWorthBobsNetWorth
A few basic observations are presented below:
  1. Amy’s savings start from $0 and grow to $100,000 in the first ten years. Her cumulative savings don’t grow after that. However, her investments continue to grow.
  2. Amy’s investment income is relatively modest in the first ten years. Whereas she saves $100,000, her investment income adds up to a total of $44,866 over ten years. Compare this with the last year of her career, when in that one year alone her investment income is $54,017, more than she earns in the first ten years put together.
  3. Bob saves nothing, and consequently has no investment income in the first ten years. His net worth is zero until year 10. From years 11 through 20, his wealth grows exactly as Amy’s grew in years 1 though 10. But then there is a departure. Bob continues to save, whereas Amy stopped saving after the first 10 years.

Sadly for Bob, he still falls short despite saving for twice as many years. Saving is hard. It involves sacrifice. Why does Bob fall short? This question can be largely answered by looking at year 11. In year 11, Bob saves $10,000. Amy saves nothing. But Amy’s investments earn $12,516. Amy’s investments are growing faster than Bob can save! Amy had a huge head start. Even though her investment income seemed small in the first 10 years, the total pile of savings and investments she built in those early years was enough to outpace Bob. In year 30, Bob’s investment income is $36,610, which isn’t small, but it is well short of the $54,017 Amy’s investments earn that year. For savers, investment income becomes sizeable as they approach retirement, as it should be. After all, in retirement, people expect to be able to live off of their investment income without reducing their net worth very much. After all, who knows how long we are to live.

My friend, the retired financial advisor, lamented that this parents hadn’t invested their money. They had government jobs. They didn’t earn much. They had to save painstakingly to retire.  But despite everything, they retired. They did one key thing right. They saved.

SciPre

This is a blog on finance and investing (see NO FINANCIAL ADVICE disclaimer below). SciPre is short for Science of Prediction.

We can roughly predict the future if we know the present and have studied the past carefully. As someone said: History does not repeat, but it rhymes. It has long been a quest of mine to understand happiness, the importance of wealth as it applies to happiness, wealth creation, the role of financial markets in wealth creation, and ultimately understanding human behavior well enough to anticipate markets.

I hope you will enjoy reading, and I welcome your comments.

NO FINANCIAL ADVICE – The information on this forum is provided without any express or implied warranty of any kind. This information does NOT constitute financial or investment advice. The information is general in nature, and is not specific to the reader. YOU SHOULD NOT MAKE ANY DECISION, FINANCIAL, INVESTMENTS, TRADING OR OTHERWISE, BASED ON ANY OF THE INFORMATION PRESENTED ON THIS FORUM WITHOUT UNDERTAKING INDEPENDENT DUE DILIGENCE AND CONSULTATION WITH A PROFESSIONAL BROKER OR COMPETENT FINANCIAL ADVISOR.