Start saving early. Learn how to save money first, then learn how to invest. We'll use risk-free strategies to accumulate savings in this episode, then introduce stock market risk in the next. Our first episode looked at developing a workable plan. Unknowns about our career, family, health, and lifespan make planning challenging.
Yet, we found some workable strategies in the face of these uncertainties. In this second episode, we'll look at when should you be saving, how should you be saving, and where should you be investing so that your savings grow faster than inflation and meets all your goals. You'll learn why your savings rate is more important than your rate of return. Then I'll show you some risk-free ways of reaching your goals.
And finally, some time-proven secrets to saving, including paying yourself first with automatic saving. Hi, I'm Rick Van Ness. You're watching the 10 Rules of Common Sense Investing, a video series about saving and investing to maximize lifelong happiness. These rules help you answer two big questions.
How much to save and how much risk to take. Time is your friend. John Bogle had a gift for colorful quotes. This is partly about exponential growth. Just as bacteria, plants, and animals can reproduce exponentially, this can happen with money.
I used to compare two women. Both saved for only 10 years. One started early, then stopped.
The other started late, but saved twice as much over 10 years. She never caught up. These stories are interesting and motivating, but are misleading without a corresponding discussion about investment risk.
So let's not get the cart in front of the horse. The primary motivation for saving is to be able to spend a smooth rate over your entire lifetime. Taking investment risk may or may not result in greater wealth and happiness.
I love the stock market, but it is not for everybody. I will talk about risk in episode 3, then investing with mutual funds in episodes 4 through 10. None of that is relevant if we don't have saving nailed down. Saving is setting aside a portion of your earnings for future use. Investing is choosing which assets to buy with these savings. Risk, for us, is the possibilities that your savings will not be there when you need them for some important goal.
It's not just about probabilities, but about bad consequences. People take investment risk seeking a higher rate of return, but that may or may not be appropriate for you, and quite frankly, you may not know yet. So let's just start with the basics. Today, mid-year 2020, the risk-free real interest rate before taxes is zero.
Risk-free means not vulnerable to the stock market, the bond market, business failures, or inflation. Let's start there, at least for our essential needs. The last episode had an example where Ed retires at age 66 with $780,000.
How do you save that much money? Is there a risk-free way? Here's how Ed did this. Ed saved 15% of his total earnings for his retirement, plus another 5% for other big purchases.
He used inflation-protected securities called TIPS and IBONS. These are used US Treasury bonds generally regarded as the safest investments in the world. An I bond is like a bank CD that grows with inflation plus has an additional fixed rate of interest.
The inflation component changes year to year. The fixed component remains fixed at whatever it is when you buy it, which today happens to be zero. It isn't always zero, but the ones you buy today are.
So let's use that. Ed sets up his automatic payroll deduction and investments from his salary. After 45 years at 0% above inflation, he would save an impressive amount, but still be a little short of his goal. We'll work on that.
Time is your friend, because it will take a lot of time to achieve this goal without introducing risk and hoping for good luck. Now remember... Forty-five years ago, Ed wasn't earning $100,000. His salary has increased with inflation for his entire career.
He was earning a lot less, so his 15% contributions were a lot less. But because they were invested in inflation-protected bonds, each one of his contributions have grown to become equivalent to a $15,000 investment today. Hey, that's a pretty powerful statement, so I want you to believe it. Let me show you.
At age 21, Ed's salary was a little above $40,000, and he contributed 15% of that. That contribution grew at the rate of inflation. and is worth $15,000 today, as did every other contribution. It's exactly as though he did 45 contributions of $15,000 in today's dollars.
A real interest rate is a adjusted for inflation. So a real interest rate of 0% has a yield that tracks the consumer price index, but nothing more. So your savings maintain their purchasing power. Wait, you say. I earn more than that.
I earn more than zero. And you show me your money market fund. Yes, these are the normal way people talk about interest rates.
They are called nominal interest rates. They are before inflation. Subtract the current rate of inflation to find the current real yield. If the current inflation rate is 1%, then these savings accounts are actually not keeping up with inflation, and you are gradually losing purchasing power. Tips and I-bonds protect you from unexpected inflation.
Inflation is currently pretty low, but here's what inflation has been over my adult years. Remember, none of us have a crystal ball. We haven't found a path for Ed to meet his savings. goal yet. His choices are to earn more, save more, work longer, change his goal, or consider investment risk.
One strategy is to earn more money. That's always a good idea, and sometimes it's the only way you're going to accumulate savings. Many of you are lucky enough to work for a company that offers a retirement program with a matching contribution.
The most common of these is when a company contributes 50 cents for every every dollar you contribute, up to 6% of your salary. This is essentially giving yourself a 3% raise. The 401 is a tax-deferred account, which we will also discuss in a later episode. I-bonds are not available in retirement accounts, but you might find a way to buy a US treasury bond called TIPS. In a nutshell, TIPS are most like treasury bonds, and I-bonds are most like bank CDs.
They're both great products. This table shows some reasons why tips are preferred by serious investors and I-bonds preferred by small savers. Note that a 3% company match is more than enough to meet the goal in this example without taking on investment risk.
What if his employer doesn't have that program or he works for himself? Andrew Tobias asserts that if Benjamin Franklin was here today, he'd update his savings to a penny savings. is two pennies earned. They didn't have an income tax back then. This update reveals that it's often much easier to accumulate wealth by saving than by earning more, after you consider the costs of working plus taxes.
For some of you, your tax rate could be as high as 50%, meaning you'd have to earn an extra two dollars just to have one extra dollar for yourself. Your tax rate could be higher than you think. If some of you earn $1,000 more, $240 will go to federal income tax, $76.50 towards Social Security, and some of you will have to pay self-employment tax, state income tax, and city income tax, the cost of getting to and from work, plus other things.
Bottom line, you may only get to spend about half of what you earn. In our example, Ed needed to save an additional $100,000 over these years. He could save a little more from... what he's already earning, or he could earn quite a bit more.
Saving more might be the easiest way to save to meet tough goals. But there are other choices. Working more years is sometimes an option. Starting to save early is one way to save more by saving over more years. This might also be smart if there may be unplanned years out of the workforce, maybe to take care of children or aging parents, perhaps an unplanned layoff.
2021 is already early because these early years must establish an emergency fund and avoid debt. Another way to finance your goals is to plan to retire later, but admittedly, that's not always an option for many types of jobs. Many of us are vulnerable to uncontrollable circumstances like recessions, wars, or pandemics.
Well, why not just choose an investment with a higher rate of return? You'd get there faster. Or would you?
Professor Zvi Bodek ...warns against taking risks to meet your important needs. Remember your hierarchy of needs, wants, and wishes from Rule Number One? Choosing more investment risk as an alternative to saving more to meet your future essential needs could be foolhardy, akin to foregoing fire insurance on your house because your budget is tight.
It might generally work out, but the consequences can be bad. Saving is challenging. You need to talk yourself into saving, especially if your friends are spending freely. So here are some time-proven tips to becoming a good saver.
It turns out that your saving rate is more important than your investment. rate of return for a long time. Let's imagine you contribute $12,000 each year and earn a very generous 8% on your investments. Each year the portion of your total balance from your investment returns grows.
It will take 17 years before your returns contribute more than your savings to your accumulating wealth. And the lower the return, the longer it will take. Even more powerful for me was adopting the concept of automatic investing early.
You don't miss or spend what you don't see. You already withhold money from your paycheck for taxes and social security. Like investing is the same concept for your long-term goals.
Direct deposit your paycheck to your bank and then set up automatic investing to your investment accounts. Ultimately, it comes down to controlling your lifestyle. People want to keep or increase their standard of living, not decrease it. Increasing slowly and smoothly helps achieve that. Some people have inconsistent income streams and should save a lot more during their peak years.
We value an extra dollar a lot more when our spending is low than when our spending is high. Economists can prove that consumption smoothing increases happiness. But I immediately recognized this truth when I heard a version of it from popular author Vicki Robin. She describes the happiness and fulfillment we get from buying things. The slope is steep when we are young.
We get a lot of happiness from a first bike, first car, first house, but incrementally less as we acquire more stuff, a bigger house, a bigger mortgage. And without even thinking about it, you become dependent on your job to pay for that stuff that you don't have to pay for. Well, frankly, you might look back on as clutter.
This concept of enough is fun to explore, along with other ways of getting happiness that don't require spending. The big idea that Vicki contributes is to think about what you buy in terms of equivalent hours of work to pay for it. Her insight goes further than our modern-day Benjamin Franklin by recognizing that your time is precious and limited. It's your life energy.
So become aware of your real... hourly wage. We saw before that there are taxes and other expenses that you wouldn't have if you were not working. Commuting costs, maybe child care, simple repairs that you hire out because you lack the time, or extra restaurant meals because you're too tired to cook.
There are also time-consuming activities that wouldn't exist if you didn't have that job. If Ed subtracts the extra expenses and adds that extra time, then the end result is his real hourly wage isn't $50 like you'd think, but rather $25. So every $25 he spends represents one hour working.
This is valuable and helps you make spending decisions. For instance, if you could buy a sports ticket for $100. $100, you would ask yourself, is it worth four hours of working to see that game?
Only you can answer that. In summary, learn how to save money first, then learn how to invest. Focus on your saving rate.
Put it on autopilot so that you don't have to think about it. Spend mindfully because you are trading your life energy. Let money be another invitation to think about who we are, how we live, and what is important.
We begin to talk about smart investing with our next episode about investment risk. And after that, learn about reducing risk by by diversifying stocks. And why bonds are different.
See you in the next episode.