When my niece got out of college, I shared with her a secret formula to become a millionaire. Are you disciplined enough to follow?
Stessy is my fictitious niece (as far as you know) who was given this plan about twelve years ago when she graduated college at age 20. I am not a financial planner, but I am pretty good at math. As I explained the details of this plan, she was a bit skeptical. One of the keys to saving enough money for retirement is understanding how money, invested at a certain rate of return, compounds over time. To illustrate this I'll use real-world numbers and demonstrate the simplicity of using a single exchange-traded fund (ETF) to diversify your investment across the best U.S.-based companies to minimize risk. To set up our model you'll need to do a few things first, they are:
Calculate an annual savings goal for your investment nest egg.
For our purposes, we'll assume you have a Roth Individual Retirement Account (IRA). A Roth IRA is a special retirement account where you pay taxes on money going into your account, and then all future qualified withdrawals are tax-free. The annual contribution limit for 2020 is $6,000, or $7,000 if you're age 50 or older. We'll use $6,000 annually or $500 a month as our goal. There are other restrictions and things to know about Roth IRAs that we'll cover in another post but for our example, we have what we need.
Pay Yourself First
Before any of your bills get paid, put your savings away.
Ideally, you want to save 20% of your income. If you are making $30,000 a year, 20% of your income would allow you to save $500 a month and hit our target of contributing the maximum allowed to your Roth IRA.
Automate your savings
The most foolproof way to do this is to set up a direct deposit from your paycheck that goes directly to your investment account. You never see the money so you don’t get used to it as part of your monthly income.
Automate your investment
In the time since I shared this plan with Stessy, commission rates on stock purchases have dropped to zero. Our chosen vehicle for this example is the tracking ETF for the S&P 500 traded under the ticker symbol SPY. The SPY closely tracks the S&P 500 and trades like a stock. Along with providing diversity across many market sectors, It also provides divided income that we will use to purchase even more shares. Each time money is contributed to Stessy's Roth IRA she has set up the purchase of $500 worth of SPY shares,
Let's look at the results
We'll start our calculations in the dark days of January 2008. We'll assume Stessy faithfully executed our plan and has invested $500 a month by purchasing shares of SPY in her Roth IRA from January 2008 through September 2020. She hung in there and never sold a share as the market swung wildly. If she had put that money in her mattress she would be very uncomfortable sleeping on a respectable nest egg of $76,500. Hopefully, she is sleeping like a baby because this lesson is about compounding and we have been purchasing SPY shares over this period. Let's have some fun, you can check my math by looking at the SPY historical data:
Scenario 1 - Stessy picks the perfect time to buy SPY every month, she makes her purchase at the lowest intraday low every month:
$500 per month invested every month from January 2008 to September 2020 with dividends reinvested would give her 574.8662 shares of SPY and at the closing price of $343.78 on October 8, 2020, would be worth $197,627.51.
$1000 per month would come to $395,255.01.
Scenario 2 - Stessy picks the absolute highest price point to purchase shares every month:
$500 per month invested every month from January 2008 to September 2020 with dividends reinvested would give her 523.9083 shares of SPY and at the closing price of $343.78 on October 8, 2020, would be worth $180,109.20.
$1000 per month would come to $360,218.40.
At 32, Stessy is well on her way to a secure financial future. Albert Einstein once said that the most powerful force in the universe was the principle of compounding. As the chart points out, in either scenario, as the appreciation of your investment begins to compound much like the compounding of simple interest, the value of your portfolio begins to multiply your money at an accelerating rate.
If the S&P 500 and its tracking ETF continue to produce similar dividend yields and appreciation, Stessy will be a millionaire by the age of 43. Not bad for sticking to a plan and saving $500 a month.