Show #404 Airing Sunday, 10/21/07
There's the old, good news/bad news joke about the pilot who's gotten lost and announces, "Passengers, I don't know where we're heading, but we're making great time." Well, when you're the captain of your investments, you can't afford to lose your way. So here to keep us flying in the right direction with a review of the basics is our financial pilot and quarterback, Jim Lineweaver.
Question: How much time do we need for investing to make a difference?
Answer: The more the better. 3 years is better than 6 months. And 10 years is a lot better than 3 years. The sooner you start saving and investing, the sooner you can let time help you accomplish your goals, thanks to the power of compounding. If you know that you are going to need a certain amount of money to meet a future goal, the power of time and compounding can help you reach that goal.
Question: Can you give us an example?
Answer: Say you need $40,000 to supplement your retirement income when you retire in 3 years. Let's also assume the investment is earning 5%.
If you had three years to save, you would need to put aside $12,688 each year. With interest, you'd have a savings of $40,000 in 3 years. So that's $38,000 out of your own pocket to create $40,000.
However, if you had ten years to invest, investing $3,180 each year, for a total of $31,800 out-of-pocket, would add up to $40,000 thanks to compounding interest.
Investing significantly less brings you close to the desired amount because of time and compounding interest. [So if you had 10 years instead of 3, you'd only have to invest about $32,000 instead of $38,000]
Question: What if our savings grow at a higher rate of return?
Answer: Just a small increase in our rate of return will make a big difference over time.
Say the investment in the preceding example was earning 7% instead of 5%.
Years of saving |
@ 5% Savings |
@ 7% Savings |
Difference 10 Years |
3 years |
$12,688 |
$12,442 |
$739 |
10 years |
$3,180 |
$2,895 |
$2,850 |
We see that both time and a minor change in the rate of return can have a great impact on helping us meet our goals.
Question: How do we let time work in our favor?
Answer: The best rule of finance to follow is to pay yourself first. We are in a society that increasingly stresses consumption. This is just the opposite of paying yourself first; it is paying everyone else first.
Look at your daily, weekly, or monthly budget. Is there anything on your list of expenditures that you can do without? I think in most cases we can all find a little wiggle room in our budgets. What if we find $25 per week that we can use to pay ourselves? Invested at 5%, at the end of five years we will have $7380 in our pocket.
Keep that up for another five years, and you had better have a big pocket because our total savings has grown to $16,856. And that is just by saving $25 per week.
Take advantage of automatic saving/investing plans that will help you do the job by withdrawing the money from your account or deducting it from your paycheck before you see it. This is a great way to get started, and as you begin to see the results you will be inspired to continue to pay yourself first for the rest of your life, and in larger amounts.
And if you can pay yourself with pre-tax money, all the better.
Question: How do you pay yourself with pre-tax dollars, and what is the advantage?
Answer: Put money into accounts that give you a tax deduction for the monies deposited. This could be an IRA, a 401(k), a 403(b); there are many types of accounts that allow a tax deduction.
Say you want to put aside $4000 per year. If you use your pre-tax dollars, you can reduce your taxable income by $3,200. If you're in the 25% tax bracket, that can result in a tax savings of $800.
Question: Any other tips?
Answer: Don't pass up free money. Participate in your employer's 401(k) plans that have a company match. If your employer has a match, for every dollar that you contribute, they will also put some money in, usually up to some limit.
Let's say that if you put in 6% of your pay, your employer will contribute another 3% to your account. That is a 50% return, before your investments have made a dime. Do not pass this up.
Are your investments working hard for you? For more information on investing basics, give Jim a call at the number that's next.
