The biggest mistake that people make when saving for retirement is simple: they get in the game too late. That’s not to say that if you’re close to retirement without much saved yet you’re out of luck – there are several strategies you can implement to get started. However, investors make it infinitely easier on themselves to hit their retirement savings goals when they start saving earlier in their career. More time in the market tends to mean greater returns thanks to compound interest.
Understanding Compound Interest
Many people are confused by compound interest. So, what is it exactly? The complicated definition is that compound interest is interest calculated on the initial principal of your investment, in addition to any interest accumulated in previous periods. However, I prefer to use a simple analogy to make the benefits of compound interest more clear.
Compound interest is a snowball rolling downhill. When you’re standing at the top of the hill, and you smash together two fistfulls of snow to make a snowball, it seems very small. When you set the snowball down and give it a push down the hill, it slowly starts to grow in size.
With every revolution of the snowball, it grows. Toward the bottom of the hill, the snowball starts growing faster and faster. As the snowball picks up snow, it’s total surface area gets bigger. That means the bigger the snowball, the more snow it can pick up as it continues to roll. The snowball isn’t going to grow at a consistent pace. It’s going to get exponentially bigger with each revolution.
In this scenario, your money is the snowball. It may not seem like much when you begin to contribute, but it will continue to grow over time. When your interest starts earning interest for many years, you’re much more likely to successfully hit your retirement savings goal.
Time in the Market Matters
Many financial planners suggest that time in the market often matters more than the actual amount invested. Let’s look at an example of why this might be true.
Liz invests $5,000 from ages 18-28. At the end of the decade, she has $50,000 in her retirement savings account. Then, Liz gets sidetracked with other financial obligations like starting a family, purchasing a home, and getting serious about paying down her student loan debt. Although she really should be contributing to retirement every year, she stops.
Joe invests $5,000 a year as well, but he’s getting a bit of a later start. He starts investing at age 28 and continues his annual $5,000 investments until he retires at age 58. He’s been investing for 30 years – way to go, Joe!
Now, let’s look at Liz and Joe’s respective retirement savings when it comes time for their retirement. Joe has successfully expanded his savings to just under $541,000 (assuming a 7% return). Liz, on the other hand, has expanded her savings to closer to $605,000 (again, assuming a 7% return). Liz has spent more time in the market, even though she didn’t invest as much as Joe, and as a result her funds have had a longer time to take advantage of compound interest.
Contribute Early and Often
I understand that it’s not possible to turn back time. If we could all be 18 again, I’m sure that there are many things we’d do differently, including starting to put money toward our retirement. However, you can take charge of your current financial situation. By starting to contribute more to your retirement now, you’ll be able to take advantage of more time in the market, and reap the benefits of compound interest as you near retirement.
Want to learn more? Contact me at Wisely Advised today, I’d love to go over how compound interest can benefit you in your retirement savings strategy.
Tony Velasquez is the Founder and Managing Director of Wisely Advised an Illinois Registered Investment Advisor. Wisely Advised provides comprehensive financial planning and investment advisory services to both individual and business clients.