One of my favourite personal finance books is The Wealthy Barber written by David Chilton. Chilton weaves his financial advice around a story of a barber named Ray who is independently wealthy. While detailing Ray’s story Chilton incorporates advice that Ray dispenses to his clients. Of the plethora of valuable advice in the book the first tenant to developing a personal financial plan and how to save for retirement is to pay yourself first.
The premise of this strategy is that you automate a 10% deduction of your take home earnings. This 10% is put into an account that is not your primary checking or savings account and will be used to save for your retirement.
Save for Retirement with the Magic of Compound Interest
In an article I wrote earlier this year, How to Quit Smoking Cigarettes I touched on the magic of compound interest (interest gained on principal and interest). After adding things up I figure spent somewhere around $20,000 – $22,000, perhaps more, over ages of 18 to 35 on smoking. This number shocks me, but what shocks me even more is that if I had invested this money and let compound interest do it’s thing – WHOA!
If I had saved $1,200 annually (instead of buying smokes) when I was 18, by now I would have $43,180 if the rate of return was 8%. Moreover, if I kept that money invested, and continued to funnel that $1200 per year ($100 per month) into saving, by my retirement age goal of 58 I would have $349,100. $1200 x 40 = $48,000 so you can see the magic of compound interest can really help you save for retirement. The earlier in life you can get started the more you can take advantage of compound interest on your savings.
How can you save for retirement then?
This compounding interest phenomenon grows exponentially if you can contribute more money monthly while you save for retirement. But how can you save when budgeting seems to work for so few? Chilton’s rule: pay yourself first. The concept isn’t complex – you find a way (your bank, your employer) to deduct 10% of your take home pay and have this money automatically deposited into an account that is difficult for you to access.
The primary point is that you never see the money in your primary bank account and your spending habits will adjust to deal with only the money you are cognizant of. Your standard of living should not be changed. To save for retirement you essentially make yourself a bill payment – much like the rent/mortgage debt , utility or telecom bill. In this case, you bill will be your future. As your earnings grow so will your contribution to your retirement savings.
To Save for Retirement, Be an Owner, not a Loaner
The key behind being an owner and not a loaner is that you shouldn’t squirrel money in a bank (loaning to them) getting lousy, low interest rates. When you deposit money into a “savings” account your bank low balls you with a low interest rate while it uses that money to invest at a much higher rate (and subsequently earn tons of profit).
Instead, you should strive to be an “owner”, as in, buy equity. You can own stocks, commodities, real estate or mutual funds. Personally, aside from our buying a home (real estate), I avoid those types of investments. Instead I prefer dividend stock investing (where the stocks can increase in value coupled with a nice dividend yield). For our dividend investing we target the major dividend aristocrat companies that we trust will be around, and be successful, for decades to come.
You can also consider investing in the index via Exchange Traded Funds (ETFs) which mirror many mutual funds sans the ridiculous MER (management expense ratio) fees actively traded funds incur. Index investing has a low PITA factor – pain in the ass factor. You are putting your money against an investment vehicle that has holdings in numerous stocks – the index.
Now all that being said, invest in what you’re comfortable investing in! There is no “right” or “wrong” way to go about investing as long as you know what you’re doing. If researching and learning the small cap market is your cup of tea, sip away! The important thing is you have decided to save for retirement.
If you have 20-40 years until retirement you can likely afford to take a long term perspective on the market. If you are considering early retirement you may need to adjust this perspective. This does not automatically mean that you should adopt the buy and hold approach, but it is a valid investing strategy when you save for retirement. The market will go up, and then go down. Nature of the beast. If you wait it out until you close in on retirement you reduce our brokerage fees and avoid trying to time the market which I read is pretty darn difficult to do.
Regardless of the path you take, if you pay yourself 10% first and keep the money invested with a decent rate of return you are well on your way to save for retirement. Just remember, the best time to save for retirement may have been 10 years ago but the 2nd best time to save for retirement is right now.