“Actually, I’ve always lived frugally and saved a lot of my income, so I don’t need to work for awhile”
It was 1999, and I was talking to a co-worker, Ron, who was about 50 years old. A large insurance company we both worked for was merging with another firm, and we were both leaving the company. (I left to start my current business).
I had suspected that Ron well below his means, because I had a good idea of how much money he made. Both Ron and his wife worked, yet they lived in a blue collar-type neighborhood with small homes.
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Ron wasn’t retiring early, but he had enough money to take some time off. He told me that he and his wife had planned financially, so neither of them would need to start working immediately after leaving a job.
They planned, they saved aggressively, and invested wisely.
This strategy can build wealth- even in times of market volatility.
What’s your end game?
The starting point to answer this question is: What’s your end game? What financial goal are you trying to reach? Knowing how much you need- and when you need it – is the first step.
Let’s say, for instance, that you want to accumulate $1 million in invested assets over the next 25 years, and that you assume an average annual rate of return of 8%. That 8% is an approximate average annual rate of return for the Standard and Poor’s 500 index of stocks. Think of this index as the broad stock market.
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Future value of an ordinary annuity
In finance, an ordinary annuity is a series of equal payments made in consecutive periods, and the annual amount you’re able to invest may be an ordinary annuity. You can plug numbers into a future value annuity calculator to find out how much you need to invest each year to reach your $1,000,000 goal.
Assume that you invest $10,500 in year one, and that you’re able to increase your invest 3% each year (as your salary or other income increases). They aren’t equal payments, but you still have an annuity.
Assuming an 8% annual rate of return for 25 years, you would be darn close to $1 million ($998,486.43).
Taking less risk
What if, instead of investing in the stock market, you simply bought certificates of deposit (CDs) at the bank for 25 years? Assuming that the average interest earned on a CD is 3%, you’d have to invest $19,700 per year to reach $1,001,151.
The goal ($1,000,000 in 25 years) is much harder to reach if you buy CDs, vs. investing in the stock market.
The savings route
If you simply cut expenses and put the money in the bank, the amount of money you have to save must be large. As a result, the only people who accumulate wealth purely by saving (like my grandmother) must do so over many decades. A bank rate of return is so much smaller, and the amount invested is larger.
A little of both
Most people accumulate wealth by:
- Creating a personal monthly budget
- Saving money each month
- Investing money saved in a diversified portfolio
It’s a little of both, because you must have the discipline to manage your spending, while you also take some risk as an investor.
My answer? Accumulating wealth requires both disciplined saving and taking some level of investment risk.
As always, this information is for educational purposes only. Consult a CPA or a financial advisor for more information.
Author: Cost Accounting for Dummies, Accounting All-In-One for Dummies, The CPA Exam for Dummies and 1,001 Accounting Questions for Dummies
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This post was originally posted on my Quora page. This post is for educational purposes only.
Image: Bullseye, Jeff Turner CC by 2.0