Everything you need to know before you build a portfolio

July 23, 2019

You’ve probably heard financial planners say that you should invest early and often! But it’s hard to think about the future, especially if it’s decades away. You might be wondering how much you are really missing out on by waiting longer to invest. And if you’re older and not investing, you may question if it’s worth it to start late or if there’s any way to catch up.

Get ready for numbers overload—we’re diving into how much money you are really missing out on by not investing! Would you believe that delaying for ten years would mean you have to double the amount you are investing! Read on for more numbers and scenarios.

Investments have the potential to grow on their own. Essentially, your money can make money!

Suppose you have a balanced portfolio of stocks and bonds that earns 6% per year, on average, and you start with $10,000. The first year you would earn $600, so you’d have a total of $10,600. The next year, though, you earn 6% on $10,600, which means you’d earn a bit more ($636).

In reality, you don’t get a 6% return every single year. Some years you’ll earn more, some you’ll earn less, and some years you’ll lose money. But the compounding still works.

Maybe the numbers in this example don’t sound very impressive. The real magic of compounding happens over time, in terms of years and decades. In ten years your $10,000 would be worth nearly $18,000. In 30 years, you’d have a little over $57,000. That’s without adding any more money to your original investment. You could quintuple your original investment, just by letting it sit and grow!

There’s an easy way to estimate how long it will take your money to double. Divide the number 72 by the average rate of return. The result is the number of years to double.

Without even bothering with actual numbers, you can see pretty clearly that the longer you have to invest, the more money you’ll have at the end. A longer investment timeframe gives you more opportunities to double your money.

Suppose we use a 6% average rate of return and start the investment clock at age 21. The money would double at age 33, then again at 45, 57, and 69. Four times.

But if you started at 31, it would double at ages 43, 55, 67, just three times. At age 41, it would double at age 53 and 65. And starting at 51, you’ve got just one doubling of your money. (These all assume you stop before age 70.)

Below, we’ll get into some numbers. We’ll use a starting amount of $1,000 and a 6% rate of return. The assumed retirement age is 65.

Note that we’re not adjusting the scenarios for inflation. There’s a 4% rule of thumb for withdrawals. If you take out 4% (or less) each year from your portfolio, you won’t run out of money for 30 years, even if there are serious recessions and depressions along the way. Having $1,000,000 means being able to withdraw $40,000 annually without worrying about running out of money.

Suppose we start the clock at age 25 with the $1,000. Obviously, even with four doublings, we won’t get to a million! So, we’ll need to add money to the account along the way.

When you do the math, starting at age 25, you’ll need to add $6,000 to the account every year to reach $1 million at age 65. This is the equivalent of $500 per month. This is essentially your annual IRA contribution.

When investing doesn’t start until age 35, then you need $12,000 per year ($1,000 per month) to get to that million at age 65. In other words, by delaying just ten years, you need to double the amount you’re investing annually. Delay twenty years to age 45, and you’ll need to contribute $24,000 every year to meet the million-dollar mark by age 65. That’s contributing $2,000 every month for twenty years!

Would you rather contribute $500 a month when you’re younger or $2,000 a month down the line? If you’re young, $500 a month may seem like a heavy lift. Many young people end up putting it off and telling themselves that when they make more money in their thirties or forties, they’ll start to contribute.

However, in your forties, you’ll probably have more responsibilities, like a mortgage, kids, etc. Will a monthly contribution of $2,000 at that time actually be any easier than $500 now?

Maybe you don’t think you can afford $500 a month, but $200 (or $2,400 a year) until you retire seems reasonable.

Starting at age 25 and adding $2,400 annually would give you about $431,000 at age 65. If you start later at 35 with only 30 years for compounding, you’d have $221,000. Starting at age 45 (20 years of growth) provides about $105,000.

Sometimes investors need to stop contributing for a while, due to life events. Surprisingly, you might actually be better off by starting earlier and then stopping, as opposed to starting later and continuing to invest longer.

As a reminder, adding $2,400 annually starting at age 35 brings you to $221,000 when you’re 65. That’s $2,400/year for 30 years.

In contrast, assume you contributed $2,400 per year starting at age 25. You stopped contributing completely after the year you turn 35, which is only 11 years of contributions. At age 35 your $1,000 has grown to about $40,000. If you then leave that $40,000 to sit and grow at 6% for thirty years, you’ll get to about $229,000.

In other words: investing for 11 years earlier gets you the same amount of money as investing for thirty years starting later.

This is the power of compounding. Use it wisely!

In the markets, investors get paid to take risks. Because they’re more volatile, equities (stocks, stock funds, stock index funds) provide a higher rate of return than either bonds or cash over the long term.

So how much of a difference does a higher return make?

Recall that starting at age 25, with a 6% return, you’d need $6,000 additional per year to reach $1 million at age 65. But what if the portfolio is invested more in bonds and cash? These conservative investments might decrease the rate of return to 4%.

The difference between 4% and 6% may not seem like much. But at a 4% rate of return, the $1 million at age 65 has decreased to about $627,000. You’ll miss out on about a third at the higher rate, just with a 2% difference!

Put differently, that same portfolio earning 4% requires $10,000 of contributions each year to reach $1 million at retirement, instead of $6,000 needed if you are earning 6%.

Imagine obtaining double-digit returns by allocating a percentage of your portfolio to alternative investments. It would take less time and fewer contributions to reach your goals! Are you inclined to be more conservative? You’ll need to save and invest significantly more money to reach your goals if so.

The power of compounding growth over time means that you don’t have to start with a million dollars to make a million dollars. If you start saving and investing in your twenties, you don’t have to save as much as you’d have to later. The difference can be huge. Invest early and often!

Making sure you have enough equities in your portfolio for your long-term goals is important too. This increases the average rate of return, so you can save less than you’d need to with more conservative investments.