From Piggy Bank to Pension

Time is the most powerful weapon in an investor's arsenal. Nothing comes close to it.

By James K. Glassman, Contributing Editor

From Kiplinger's Personal Finance magazine, February 2006

Retirement planning begins in your twenties or thirties -- or, better yet, at birth. That's when you should start investing to build a nest egg of stocks and bonds big enough that you can live off the income and capital gains, rather than off the sweat of your brow and your brain. After 30 years of studying finance, I have found few eternal truths, but the most important -- the Golden Rule of Accumulation -- is this: Start early!

Compound your gains. Time is the most powerful weapon in an investor's arsenal. Nothing comes close to it. In your fifties and sixties, or even your forties, you probably won't have enough time to build a substantial retirement portfolio -- unless you own a business, work for a company that doles out generous pensions or have made some profitable gambles in real estate.

Let's do the numbers. The annualized return for U.S. large-company stocks (as represented by Standard & Poor's 500-stock index) for the past 80 years has been about 10%, not including taxes. Say your goal is to build a nest egg of $1 million by the time you are 55. If you start at age 24 and invest $5,000 a year at an annualized return of 10%, you'll reach your goal. But if you wait until you are 34 to start, you'll accumulate only $357,000 by age 55. If you start at age 44, you'll have just $107,000.

Here's a second example, even more dramatic. Ishmael begins at age 25 to put $2,000 a year into a low-expense mutual fund with an annualized return of 10%. At age 35, he's put $20,000 into the fund. Then he stops investing entirely. But the value of Ishmael's holdings keeps rising, and by the time he is 65, he has a portfolio that is worth $556,000. (We are assuming this is a tax-deferred account, such as a 401(k) or an IRA.)

Now, consider Isabel. She, too, invests $2,000 a year at 10%, but she waits until age 35 to start. She keeps investing for a full 30 years -- a total of $60,000 out of her pocket. At age 65, Isabel's got just $329,000.

In other words, those extra ten years (between ages 25 and 35) produce nearly 70% more money for Ishmael at retirement, even though Isabel's out-of-pocket investment is three times greater.

How can this be? The answer lies in compounding, the fact that interest increases the value of interest as well as the value of principal. If you earn 5% on $1,000, after a year you'll have $1,050. After two years, you'll have not $1,100 but $1,102.50.

As time passes, the power of compounding accelerates dramatically. Imagine that when your daughter is born, you give her a one-time gift of $10,000 worth of stock. Assume that the stock appreciates at 10% annually. On her tenth birthday, your daughter's account will be worth $26,000 (I am rounding up to the nearest thousand in all cases); that is, it will grow in value in that first decade by $16,000. But over the second decade, her account will grow by $41,000; over the next, by $107,000; over the next, by $278,000.

What to expect. One other important fact about compounding is that a small increase in the rate of return can produce a huge impact over time. In the case of the gift to your newborn daughter, if her portfolio returns 10% annually, then $10,000 grows to $4.5 million by the time she is 65. But if her portfolio returns 8%, then it grows to only $1.4 million. If it returns 5%, it grows to a mere $227,000. In other words, half the rate of return produces an account that's less than one-twentieth the size.

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