As young investors begin investing it is important they get off on the right track. Picking lousy investments or paying extra taxes really add up over the course of a lifetime.
Here are 5 things you can do to ensure you reach that million dollar mark.
1) Budget in Extra Savings
In order to effectively manage your money you have to know where it is going. If you have been reading BeginToInvest.com for any time at all you know how important saving early is. For young investors the trick is finding where to cut expenses in an already tight budget. Nothing helped me more than being able to see everywhere my money was going.
Those few trips to Starbucks don’t feel that expensive on their own, but when you can see an annual total for your Starbucks trips for the year it will hit home. Just 2 trips a week can cost you more than $800 per year if you are getting anything more than plain coffee! After a year of tracking expenses I found my budget busting item was eating out – and ordering a drink or two while there. Too frequently this added up to over $200 a month!
Just seeing the totals may very well be all you need to start getting extra unnecessary expenses under control.
There are some very popular free personal finance websites, my favorite of which is Mint.com. I have been using Mint.com for many years now. It automatically update bank balances, credit card balances and track transactions that makes it nearly effortless to set up and keep on a budget.
The first step for anyone looking to squeeze a little more savings out of their paychecks is to create and stick to some kind of budget.
Lets get started making a simple budget using a website like Mint.com:
- Start with how much you make each month.
If you are paid bi-weekly as many are, simply take a normal paycheck and multiply by two. Of course for most, there are two months out of the year you get 3 paychecks a month. Don’t factor those in here – create a budget without them factored in and you will have some extra money those 2 months! Use it for extra savings, paying down debt or something special.
For me, my paychecks before taxes or any other deductions are taken out ends up around $1900. After health insurance, 401k contribution and taxes it is down to about $1300. Multiply by 2 and I am left with about $2600 per month.
- Next step is to start with an idea of how much you need to save every month.
Notice, we are not starting by taking expenses out first. Make savings your first priority. In an article here we showed how much you need to save every month to reach $1 million by age 65. Use that number as a figure to get started.
For me, that was about $400 per month. I am able to save a little but more, so after additional savings, my monthly income left over is down to about $2050.
- Next, start with big monthly expenses that are a set amount each month. Things like mortgage or rent, car payment etc.
Big ones are rent at $625 and car payment $350.
What started as $2050 per month is dropping fast – now down to $975 per month left to spend.
Everyone will have different expenses that are different priorities. Maybe for you daycare costs go here, or student loan payments. The important thing is to start a budget with your savings and big ticket items already accounted for.
Many people create budgets by starting out with factoring small expenses. They may take into account Starbucks trips, eating out or grocery expenses and end up leaving themselves nothing left to save. Instead, tackle your big priorities first, factor in extra savings and then find out what room you have for small items.
I couldn’t help but relate this to Stephen Covey’s “Seven Habits of Highly Effective People”. The third habit in his best selling book is “put first things first”. In it, Stephen talks about tackling the big issues first and then worrying about the small things.
Think of all the small green rocks as all the little expenses you have every month, and the big rocks as things like your mortgage, car payment and amount you need to save.
The video may be a bit cheesy, but exemplifies why this works.
Force yourself to budget in big ticket items AND additional savings first, then worry about the small things.
How effective can this be on your road to becoming a millionaire?
When starting at age 25, being able to invest an extra $100 a month at a 7% return (roughly the average the stock market has returned historically) means an extra $350,000 by age 65!
2) Save Every Month – Regardless of Market Performance
Investors have a poor history of timing the market, and it is the primary reason individual investors lose faith in the stock market. When the market is soaring and is all over the news, people are buying. This is also at times when the market is typically at multi-year highs and is historically very expensive. When markets decline people pull their money out of the markets – usually for a loss since they bought when the market was at its height.
Take a look at how investors timed the market during the most recent 2008 market decline:
In the chart below positive numbers indicate the amount of dollars (in millions) that investors bought in stock funds. A negative number indicates that investors sold that many dollars (in millions) of stock funds.
A positive number (inflows) indicates heavy buying, while a negative number (outflows) indicates heave selling.
|Investment Company Institute
|(Dollar Figures in Millions)
|Monthly Net New Cash Flow
Notice the tremendous outflows during late 2008? That is precisely the time when investors should have been buying! Instead investors sold, at near the lows of the market likely for a substantial loss.
The largest inflows were early 2007 – over $50 billion in the first 2 months!
The largest outflows were September and October 2008 – Over $200 Billion pulled out of the stock market the last half of 2008!
Find those dates on the chart below:
In 2007, markets the S&P 500 index was near its all time high – and investors were buying hand over fist
In late 2008 the market had sold off nearly 40% – and investors were selling like the world was ending.
The average investor nearly nailed the tops and bottoms of the stock market! Unfortunately they were doing the opposite of what they should have been doing.
The $200 billion in outflows from late 2008 would be worth over $300 billion today if it was simply left in the market!
Of course it’s easy to look back in time and say investors should have bought here or sold here. But there is a way investors can ensure they are buying at appropriate times.
It involves simply investing at regular intervals – regardless of whether the market has gone up or down.
The practice is common for investor’s 401ks, where money is taken out of each paycheck and invested. This is a main reason 401ks have been such a successful investment vehicle for small investors. Typically 401ks are setup and left to grow for decades and not subject to emotional buying or selling like other accounts. They are simply added to every 2 weeks whether the market is up or down.
But investors rarely do this for money in IRAs or traditional brokerage accounts – as evidenced by the numbers above. Or worse, they change their asset allocation within their 401ks during significant market moves.
This strategy for investors is called “Dollar Cost Averaging” – and is vital to your long term success investing in the stock market. Since it is impossible to time the market accurately, instead just buy at set intervals – no matter what the market is doing.
The annual contribution limit to a Roth IRA is $5000. When the market is falling, many investors choose not to invest that $5000, and when the market is soaring they invest all $5000 at one time – usually at market highs.
Instead split the $5000 into quarterly investments of $1250. In January, March, June and September invest $1250 into the market. Invest that $1250 whether the market is soaring or falling, whether the news says buy or your neighbor says sell.
Benjamin Graham – The “Godfather” of Value investing and mentor of many famous investors such as Warren Buffett – in a 1963 speech talked about the effectiveness of long term dollar cost averaging:
“Another approach that is practicable, but from a different point of view, is the “dollar averaging” method, in which you put the same amount of money in common stocks year after year, or quarter after quarter. In that way you buy more shares of stocks when the market level is low and fewer shares when it is high. That method has worked out extremely well for those who have had (a) the money, (b) the time and (c) the character necessary to pursue consistent policy over the years regardless of whether the stock market has been going up or down. If you can do that you are guaranteed satisfactory success in your investments.”
Over the course of history, very few investments have returned more to investors than the stock market. But investors only get this return by staying in the market and continuing to buy regularly.
How does this step contribute to your goal of a million dollars?
According to a 20 year study done by Dalbar, Inc. ending December 2010 cited in an economic times article here
The average return of the S&P 500 during the 20-year period was 9.14%.
The average return earned by the equity investor during the same period was only 3.27%
A low cost index fund will nearly perfectly match the performance of the S&P 500, so matching the S&P performance is easy. The underperformance is because investors are euphorically buying at market tops and selling scared in market declines.
What is the difference in those returns to your retirement portfolio?
To find out we use a retirement calculator from Scottrade found here
If you invested $10,000 today and added $100 per month with an annual return of 3.27%:
Your money would grow to about $85,000 over 30 years.
Compare that to how much money you would have if you instead had a 9.1% annual return by simply owning an S&P 500 index fund over that period:
By saving $10,000 today and adding $100 a month, with an annual return of 9.1%, your investment would be worth over $340,000 in 30 years!
That is a difference of $255,000 for just $10,000 invested!
3) Keep Fees and Taxes Under Control
Investors face many different fees when investing.
For investors unwilling to manage their finances themselves they pay asset managers annual fees of upwards of 2% of assets per year – $20,000 per year if you have a million dollars!
Even for investors willing to do some work themselves, they may choose to invest in mutual funds. The average annual fee charged by a stock mutual fund today? .79% of assets!
This is unfortunate because today it is easier than ever to construct a dirt cheap portfolio.
Companies like Vanguard, Charles Schwab and Scottrade offer ETFs (Exchange Traded Funds) with annual fees as low as 0.05%!
How do these fees add up for the average investor?
Recently the Wall Street Journal cited some research from Vanguard on just how those fees add up.
Given a 6% annual return (slightly below historical average), every 0.1% increase in expense ratios cost the investor $10,591 per $100,000 invested.
What is the difference between the industry average 0.79% expense ratio and paying 0.05% per $100,000 invested over 25 years?
For ideas on other low cost investing options, check out our “ETF spotlight Series ” where we highlight other low cost funds that are worth a look.
For those investors that use an asset manager, your savings can be even greater. It is well documented that on average asset managers underperform the market.
Most recently, Certulli Associates, a financial-research firm out of Boston came out with results from a study of average returns from asset managers. They have calculated the average return from the last two years of two different asset management styles and compared them to a benchmark of a blend of stock funds and bonds.
According to their study, funds ran by active managers, those who constantly “tinker” with investor’s asset allocations, substantially underperformed the market. Active managers are those who generally charge the highest fees, “justified” by the time they spend researching, and based on all the fees that add up from them buying and selling securities. Certulli Associates calculated that the average annual return from these types of funds over the past 2 years has been 2.1%, compared to a benchmark of a simple balance of stocks and bonds, something very easily achieved by the individual investor, which returned 7.7% annually.
How does an annual return of only 2.1% compared to 7.7% hurt your investment growth?
If you invested $10,000 today and never added another penny and let it sit for 30 years at 2.1% annual growth, you would end up with a little more than $18,000.
Compare that to if you invested $10,000 today, never added another penny to the account and let it sit for 30 years at 7.7% annual growth:
You end up with $100,000!
Firing your asset manager and buying a balance of cheap index funds can net you over $80,000 over your lifetime!
There is a more significant cost than just fees for most individual investors – for the average investor the largest bane on their portfolio is taxes.
Investors pay income tax on money before it is invested (except in 401ks) and short term or long term capital gain tax along with taxes on dividends they receive for other accounts.
Simply taking advantage of several tax shelters available to individual investors can save investors hundreds of thousands of dollars over a lifetime.
The largest tax many people face is the tax on long term capital gains on their investments. In a traditional brokerage account, Traditional IRA or 401k investors pay taxes on capital gains upon withdrawal. If you have worked for decades and saved up a million dollars in your traditional IRA, you may face hundreds of thousands of dollars in taxes withdrawing your savings. That million dollars can easily be less than $850,000 after taxes have been taken out!
This is the benefit of a Roth IRA. The money you contribute into the Roth IRA has already been hit by income tax, but that money grows tax free for life!
A 25 year old investor looking to reach $1 million by retirement at age 65 needs to save about $420 per month.
Over 40 years this 25 year old investor would have saved $200,000 ($420 per month, for 40 years) by the time they are 65. The extra $800,000 comes from compounding interest on their investments.
If this investment was in a 401k, traditional IRA or traditional brokerage account you would pay taxes on that million dollars. How much you pay depends on your tax bracket:
Your tax bracket in retirement depends on income you have from pensions, social security and interest from various investments. For the large majority that puts you in the 15% or 25% tax bracket.
So every withdrawal from your 401k or traditional IRA is going to be taxed at least 15%. As you slowly withdrawal your million dollars to pay for expenses during retirement, you will pay at least $150,000 in taxes!
If that investment was initially done in a Roth IRA, the taxes you would pay upon withdrawing that million dollars would be:
Never pass up investing in a Roth IRA. Roths have a $5000 annual limit and should be your primary investment account, behind only contributing to your 401k up to your company’s match. For much more information on all the various types of accounts such as a Roth IRA, 401k and traditional IRA and how they fit into your financial life – check out our article here.
So, the average investor could easily save $75,000 picking low fee funds, $80,000 by firing their asset manager and at least $150,000 by investing in a Roth IRA instead of another account type!
4) Savings Inflation
“Lifestyle Inflation” is the idea that as you grow older and make more money, you also spend more money. To an extent, this is expected to happen. As you work hard at your job and get promotions – you should be able to enjoy a few more things. Maybe a vacation, nice diners with the family or whatever else pleases you. No one expects someone who makes $100,000 should not have anything that someone making $40,000 does.
However what many people forget to do is increase the amount they save with each raise they get at work.
Lets say you start your job making $40,000 per year, and receive a raise of 3% each year.
And lets also say that your goal is to save 10% of your income.
The first year of your job you save $4,000.
But the next year you get a 3% raise – your income is now $41,200.
For most, that extra $1,200 doesn’t go into savings. Instead it is used to help “Keep up with the Joneses”. Maybe a nicer car or bigger TV.
But lets instead be responsible and keep saving 10% of our income. So now, the second year of your job you are saving $4,120.
Note, you got a raise of $1,200, and only invest an extra $120 (10% of it). You still have most of your raise to enjoy or save if you desire.
This process continues as you work for the next 30 years.
What difference would it make if you only saved $4,000 per year, without increasing as you get raises, compared to saving 10% of your salary as it increases?
(This example assumes a 6% return on investments.)
(click image to enlarge)
A difference of nearly $120,000!
This is what I like to call “savings inflation”. Don’t forget as your salary increases to also give your savings a little boost as well.
5) Keep a Goal in Mind
Lastly, start thinking about how much money you will need in retirement before you get there.
When you retire, you no longer have traditional income from a job, and instead must live off of savings and the interest from your savings.
As you age, start thinking about what kind of income you will need when you are older.
Several hundred dollars a month for a car payment, several hundred more for groceries, and maybe you want to take the grandchildren on a vacation.
Whatever the costs add up to, have that number in mind. Lets say it is $35,000 per year to cover you expenses.
If you have $1 million and get 3.5% interest on that million dollars – you have your $35,000 per year. That is $35,000 per year you get before you have to withdrawal even a penny from your savings! This means that your million dollars stays intact to generate you another $35,000 the next year.
By figuring out this number far ahead of time, you give yourself a goal to reach towards. Instead of just “saving as much as I can” – which inevitably leads to not saving as much – you can determine a specific amount you need to save every month to meet you goal. Then use step 1 in this article and make a budget around saving that amount every month to ensure it happens.
Many people are currently struggling because of poor planning. Today almost half of the people who pass away have less than $10,000 in savings remaining. That means they are relying almost entirely on social security for income which for most is hardly enough to enjoy retirement, let alone eat.
Don’t be caught off guard when it comes to retirement. Have a goal to reach for that will keep you well off during retirement.
Adding these savings from these steps all together; $350,000 by budgeting in an extra $100 per month for savings, $225,000 by “staying the course” and investing every month regardless of the market, $75,000 by picking low cost stock funds instead of industry standards, $80,000 by managing your own money and not paying an asset manager and $120,000 from increasing your savings every year you get a raise.
All together these add up to an additional $850,000! – A savings that will get you well on your way to a becoming a millionaire.
Now, I could have added an additional item to make it $1,000,000 instead of only $850,000 but instead I think it is better we all learn from each other.
Whats your best tip for saving money or increasing investment returns?