The advantage of saving
While saving and investing go together like PB and J, accumulating money through savings is the main mechanism that makes investing work.
"An average saver will do better than a great investor who doesn't save," says David A. Schneider, CFP professional and principal at Schneider Wealth Strategies in New York City.
"Let's say you are in the rare group that can outperform (the market by) 2 percentage points per year -- few can do that. But you can't accumulate as much as someone who was more of an average investor but saved in a disciplined and consistent way," he says.
That's because adding extra savings to your portfolio gives compound interest more money to work on.
The chart below shows 2 investors who begin with $100,000. Investor A adds $10,000 to the pot at the beginning of each year over 20 years and gets a 10% return. Investor B adds nothing and gets a 12% return for 20 years.
Even with the advantage of a higher return, Investor B falls behind Investor A. If B gets the same 10% return over 2 decades, his portfolio grows to about half of A's over that time. In order to earn the higher rate of return, Investor B would need to take on more risk -- which could turn ugly in a market downturn.
Focus on what you can control
There will inevitably be market downturns. But there are ways to make the volatility of the market work in your favor. Continually adding to investments ensures that savers buy at low prices as well as high prices through a process called dollar-cost averaging.
"The only thing that you can control is the amount of capital you invest. Even during periods of low market returns, the frequent addition of investment capital can have a lasting effect," says Bob Stammers, CFA, director of investor education for the CFA Institute.
"Consistently adding capital to your portfolio, as well as the long-term returns earned on that capital, is an excellent way to steadily move toward your overall financial goals," Stammers says.
It takes money to make money
The magic of compound interest is more impressive with a big pile of money.
The "rule of 72" gives savers a quick rule of thumb as to how long it will take their initial investment to double at a given rate of interest. Simply divide 72 by the rate of return you expect to get in order to find out how long it will take your investment to grow twofold. For instance, 72 divided by 6 means it'll take 12 years to double your money.
No matter how large your portfolio, it would take about 7 years for an investment in the stock market to double at the 10% historical rate of return.
No one would turn down a 100% return on his or her money, but doubling $100,000 is better than doubling $100.
Time is short
Regular saving is only half the battle. Investors need time for compounding to work on their money. Compounding occurs when the earnings of an asset are reinvested and then generate their own earnings, creating a snowball effect.
"Time is one of the most precious resources for a successful retirement," says Phillip Christenson, CFA, financial planner and portfolio manager at Phillip James Financial in Plymouth, Minnesota.
The chart below shows how time impacts savings. By saving $5,000 at the beginning of each year for 20 years and earning an 8% return, Saver A ends up with $247,115 after 2 decades. Saver B has other things going on in the first decade and doesn't start saving until he's only 10 years away from retirement. To end up with the same amount as Saver A, he'll have to put away $157,946 over 10 years' time, or about $15,795 each year.
The early saver squirreled away $100,000 over 20 years, and earned $147,115 from compounding earnings. The late saver had to make up for lost time, ponying up $157,946, and earning $89,169 over 10 years, assuming the same 8% rate of return.
If the person with the early start saved $14,000 annually for 20 years, she would end up with $691,921.
Like getting physically fit, getting financially fit takes hard work and the ability to say "no" to temptation.
"Everyone wants the 6-pack abs -- but are they willing to do the work?" says Michael Silver, CFP professional and partner at Baron Silver Stevens Financial Advisors in Boca Raton, Florida. "Everyone wants to retire with a lot of money at some point, but are they willing to save and be disciplined with their spending in order to do that?"
Start early, save hard and let compound interest get to work.