One of the most common pieces of retirement investing advice you’ll hear is to start early—or at least as early as possible.
“There’s no substitute for getting a good start on your financial future,” wrote Brian O’Connell, chief strategist for our new 401k Millionaire service, in a recent Investing Daily article. “All the studies show that the earlier you get going, the more money you’ll have in retirement. That’s because the earlier you start, the earlier compound interest goes to work for you.”
Harnessing the Power of Compound Interest
Younger investors often overlook the power of compound interest, but if you can set aside a small amount of money every month and stick to your program, the results can be dramatic. Even better if you can set aside, say, between $ 100 and $ 500 a month.
To illustrate both ends of that spectrum, let’s look at two hypothetical 25-year-old investors, Henry and Marie, both of whom are keen to get started on their retirement investing. Henry can afford to set aside $ 100 a month (or $ 1,200 a year), while Marie is fortunate enough to be able to tuck away $ 500 a month ($ 6,000 a year) for her golden years.
Let’s also assume a hypothetical 10% average annual rate of return, compounded monthly. By age 50, Henry’s savings would have ballooned to $ 133,789. That’s not bad, but Marie would be sitting on a plus-sized nest egg of $ 668,945.
The moral? As far off as retirement seems, getting going early is well worth the trouble. And setting aside as big a chunk of money as possible every month is a real game-changer.
Your older self will thank you for it.
Stocks: The Only Game in Town
To put themselves in the strongest position for gains, O’Connell and Investing Daily editorial director John Persinos, the experts behind 401k Millionaire, advise younger investors to take advantage of their long time horizons and focus on stock mutual funds in their 401k plans.
“The fact is, 401k plans are long-term money. And over the long term, stocks have outperformed every other investment vehicle,” wrote Persinos in a recent Investing Daily article.
“We’d never advise putting all of your eggs in one basket. But the younger you are, the more heavily you should weight your 401k portfolio toward stock mutual funds. This emphasis on stocks should diminish as you get closer to retirement.”
A Primer on Dollar-Cost Averaging
One way to invest in the market for the long haul is through a technique called dollar-cost averaging. The name sounds complicated, but you’re actually already doing it if you invest part of your paycheck in a 401k or other employer-sponsored retirement plan.
The concept is simple: under dollar-cost averaging, you commit to buying a fixed dollar amount of a particular investment on a regular schedule, usually monthly, without regard for the share price. This way, you naturally buy more shares when prices are low and fewer when they are high.
Dollar-cost averaging is a good way for young people who don’t have a lot of money to start investing. Younger investors’ long time horizons also give them an advantage here, because the market’s long-term course is generally higher: the S&P 500 has posted an annualized return of 10.5% over the last 25 years, for example, though it has varied widely on a yearly basis.
Dollar-Cost Averaging: A Case Study
Let’s take a closer look at how it works. We’ll use shares of FedEx (NYSE: FDX), which many investors see as a bellwether for the global economy, as our model in this scenario. (O’Connell published his latest analysis of the stock on Investing Daily yesterday. Click here to read it.)
FedEx, along with the wider S&P 500, has moved in a wide range over the past decade, so for the sake of this example, let’s say you’ve committed to buying $ 2,000 worth of FedEx stock annually on the last trading day of the year. We’ll also build in a 10-year timeframe, starting on December 31, 2004, when you would have made your first buy. On that date, FedEx closed at $ 98.49.
If you had bought FedEx on the last trading day of the year every single year between December 31, 2004, and December 30, 2013, your price would have ranged from just $ 60.14 in 2008 (when your $ 2,000 would have gotten you 33 full shares) and $ 143.77 (or 13 shares) in 2013. However, your average purchase price would have been $ 95.76 a share, below the stock’s average of $ 121.13 during the period. You would also be well ahead of today’s price of $ 140.19.
A bonus? Dollar-cost averaging is a great way to ease anxiety: if you’re simply putting money into a certain investment on a regular basis, you can block out the ever-present temptation to try to buy low and sell high, acting on which, studies show, usually does more harm than good.
Something to keep in mind, though, is that while dollar-cost averaging is a good way to invest money as you receive it, it’s often not as effective for investing a sudden windfall.
In that case, you’re likely better off investing it all at once rather than easing your way in, according to a 2012study from Vanguard. Over a 10-year time period, researchers found that lump sum investing outperformed dollar-cost averaging roughly two-thirds of the time, due to the superior returns of stocks and bonds compared to cash in the study’s timeframe.
Our 401k Millionaire Permanent Portfolio system has returned 9% to 10% a year—straight through the roughest weather in market history. This is exactly the type of performance you need to secure the comfortable retirement you deserve. Find out how to put this rock-solid system to work on your retirement account today by clicking here.
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