I'm just starting out in my career and have managed to save up $1,500 dollars so far. I want to start saving more and invest it in a way that can best put the benefits of compounding investing to work for me. Any suggestions? — H.M.
Your question shows that you're already on the right track, by which I mean that you seem to get the fact that to build wealth and achieve financial security you need to both save and invest. That may sound like an obvious notion—and it is—but nonetheless too many people put far too much emphasis on the investing part and tend to neglect the saving part.
In fact, I'd go so far as to say that while saving and investing are partners in building wealth, saving is the more important of the two. It's possible to accumulate wealth solely by saving (although I don't recommend you limit yourself to saving alone). But you can't generate wealth just by investing, as without savings you'd have nothing to invest. And even the savviest investing in the world can only do so much if you're not saving regularly.
Here's an example. Let's say that you invest your $1,500 in a diversified portfolio of funds that earns six percent a year. And let's further assume that to get the benefits of compounding—i.e., earning interest on interest or a return on your investment returns—that you reinvest all your investment earnings in additional fund shares (something pretty much all funds will do for you automatically if you choose).
After 40 years, your $1,500 would have grown to just over $15,400. Not bad, but hardly enough to set you up for life or to fund a secure retirement.
But look what happens when you continually throw more savings into the pot. If, for example, each year you save an additional $1,500 and invest that alongside your original $1,500 and continue reinvesting all your investment gains, after 40 years you would have just over $246,000. Now we're beginning to talk about real money.
What you might find particularly interesting about this second scenario of saving and then investing $1,500 a year is that by the 12th year the amount you're adding to your stash through re-invested earnings actually exceeds the $1,500 a year you're saving. Indeed, by the end of that 40-year period, your re-invested investment earnings each year would total nearly 10 times the $1,500 in savings you're kicking in. That shows just how much compounding can work for you when you combine regular saving with investing.
Look What Happens When You Save More
But you can probably do even better. After all, when you're just starting out, scraping together $1,500 a year to save may be a challenge. But as you advance in your career and earn more, you ideally should be able to save more without crimping your lifestyle too badly. And by increasing the amount you save as your salary increases, you can really start to see the bucks add up.
Let's take the case of someone who's 25, earns $35,000 a year and receives two percent annual pay raises. If that 25-year-old saves 10 percent of salary each year and earns a six percent annual return on that money, by age 65 that person would have just over $725,000. Push that savings rate to 15 percent—the target recommended by many retirement experts—and our hypothetical 25-year-old's stash would crack the $1 million mark.
I'm not suggesting you can duplicate these figures exactly. Neither I nor anyone else can precisely predict what returns the financial markets will deliver over the next 30 to 40 years (although many investment firms believe returns will come in lower over the next decade or so than in the past). More importantly, even the most committed savers may experience bouts of unemployment, health problems or financial setbacks that knock them off their savings regimen.
The point, though, is that if you really want to build wealth and create financial security for yourself, you need to save diligently and invest sensibly. And you should start ASAP, as even a few years of procrastination can significantly reduce the size of your savings balance. (For example, if the 25-year-old above waits until age 30 to start saving 15 percent a year, his age-65 account balance would shrink by more than 20 percent.)
Tips For Saving On A Regular Basis
So as a practical matter how do you do this? There's no shortage of ways to save money. Some people use budgeting software to track their spending in dozens of categories (lattes, clothing, telecom fees, dining out, etc.) to find places to reduce outlays and squeeze out some savings. Others like to use savings apps that invest your spare change or rely on algorithms that periodically shift money into savings supposedly without you noticing it. If such systems work for you, fine.
Personally, I prefer a simple system of setting aside a certain percentage of salary upfront—ideally 15 percent, but you can start with a lower figure and gradually increase it -- and having that amount directly deducted from your paycheck and put into a 401(k) or transferred from your checking account to a mutual fund account. I like this arrangement because it makes saving automatic, ensuring that the money you intend to save actually gets saved, not spent (which is usually the more likely outcome). But whatever method works for you is fine, as long as you actually end up saving on a regular basis.