I came across an article from Zach @ Four Pillar Freedom where he talks about the time it takes to reach $100,000, $200,000, $300,000 etc. It got me thinking about the factors that influence our final retirement portfolio value. I could think of three factors (1) duration of investment, (2) rate of saving or investment and (3) return on investment.

I think of the retirement value as the area of the triangle formed with the above three factors as three sides. In an ideal world we would like to maximize all three. In a more realistic situation, one factor needs to compensate for the lack of other two.

For my analysis, I assume one million dollars is sufficient for a happy retirement. It is debatable whether this amount is sufficient for retirement, but I am very sure most of us would be very happy to have a million dollars. I have assumed the retirement age to be 65. In the worst case we would like to have a million dollars by the time we are 65 years old (earlier the better).

In my calculations to compute returns on a pure stock portfolio, I used Total Stock Market Index Fund (VTSMX). Since its inception on 4/27/1992 VTSMX has average annual returns of 9.96%. So, an all-stock portfolio is assumed to have a return of 9.96%. Similarly, for my all bond portfolio, I used Total Bond Market Index Fund (VBMFX). Since its inception on 12/11/1986 VBMFX has average annual returns of 5.89%. I use a linear combination of VBMFX and VTSMX to compute returns on diversified portfolios. For e.g. a 50% stock and 50% bond portfolio would have annualized returns of 7.93%.

In the first scenario, let’s say a person starts investing $6,000.00 per year at the age of 22. $6,000.00 per year comes out to be $500.00 per month and should be something an average person can afford to invest. In fact it is very close to the contribution limit for IRA ($5,500). We vary the return on investment from a very conservative portfolio i.e. 100% in bonds to a very aggressive portfolio i.e. 100% in stocks. The power of compounding and time is very obvious from this chart. Even with a very conservative portfolio it is possible to reach a million dollars at an age of 63. The other investment strategies are faster with an all stock portfolio getting us there at age of 51. The thing I like the most about this scenario is we can be totally risk averse and still attain our goals. Since, I did not consider inflation adding stock components should compensate for it.

In the second scenario, let’s say a person still continues to invest $6,000.00 per year. But, instead of starting at the age of 22, we try out multiple start points i.e. 22, 27, 32, 37, 42 and 47. There is not much of a difference between starting at ages 22 and 27. With a ROI of 7% (Conservative portfolio) it is possible to reach our goal of million dollars. Starting at age of 32, we are looking at a very aggressive portfolio to reach our goal. At 42+ even an all stock portfolio is not going to be successful in getting us to our goal. The only alternative is to than increase the contribution (see next chart).

For the third scenario, let’s assume a ROI of 8.75%. This corresponds to an aggressive portfolio with 70% invested in stocks and 30% invested in bonds. Again, instead of starting at the age of 22, we try out multiple start points i.e. 22, 27, 32, 37, 42 and 47. Since, the ROI is fixed the contributions have to increase to help us achieve our goal. It is still possible to achieve our goal by investing 6,000$ per year as long as you start ahead of 32. Starting 37, we need to invest 9,000$ per year to meet our goal. This is because diminishing effect of compounding. It goes all the way up to $23,000 per year at the age of 47. One thing to keep in mind is that wages do increase with work experience. So, even if we miss the boat at a younger age, we could still reach our goal by saving/investing more (thanks to wage increases we might be able to afford it). Catch up contributions to IRAs and 401s provide us this opportunity.

This is a dividend investment blog. Hence, I wanted to finish off with a dividend reinvestment example. For this illustration I am going to use the S&P 500 index. Historical data on S&P 500 index is publicly available on Robert Shiller’s website. The data is quite exhaustive and includes data from 1871(Yes! S&P 500 index is really old). Furthermore, I will be using a 50 year time period i.e. 1967 to 2017. One thing to consider is 500$ was worth a lot more in 1967 (thanks to inflation, debt level etc.). So, in my computation, I computed dollar adjusted values by normalizing with 2017 CPI (consumer price index) value.

Let’s say I have been investing $6,000.0 per year in the S&P 500 index from 1967. The only growth I had in my investment was from dividends reinvestment i.e. dividend yield is my annualized return. How much would by portfolio worth be in 2017? It would be worth $618,373.89. Using the average yield of S&P 500 from 2017 our portfolio would generate $11,986.73 in passive income.

In conclusion investing early and often is a sure shot method to a successful FIRE. We have seen that the most dominating factor is not the amount invested or the investment ROI. The most dominant factor is time. Starting early with a modest monthly investment (let’s say 500$) and investing in a moderately conservative portfolio is a good investment strategy. For someone who has been unable to invest early, contributing a larger amount is a good strategy. It might be possible to take advantage of catch up contributions after age of 50.

Excellent article DG. I like the quote “save as much as you can, as early as you can, for as long as you can”. With the emphasis on start early. All three are important but time is the most dominant factor.

ReplyDeleteThe quote pretty much sums up my article. Thanks Steve.

DeleteGeek -

ReplyDeleteIt's simple - save, invest and do it as much and as early as you can! Loving it.

-Lanny

Yes it is that simple. But, unfortunately not many people do it ... including me. Hope it changes :-)

DeleteNice analysis Mr. Geek. For what it is worth, most studies show a 60/40 equity to bond split has the greatest risk reward profile. Going higher in equities and you don't pick up enough additional return to compensate for the extra risk. Tom

ReplyDeleteThanks Tom. That's interesting to know. I always though it was 70/30. Will research.

DeleteGreat analysis Mr. Geek:)

ReplyDeleteThanks Caroline.

DeleteIt's kind of like being in a race and starting out strong. Once you get that comfortable lead, you can take your foot off of the gas just a little bit, but still keep you eyes on the prize. :-)

ReplyDeleteI started at an early age, and if I knew then what I know now, I would have piled it on right from the get go.

I agree mate! Its not bad even now. All it means is we need to save and contribute a lot more. I started at 35.

DeleteExcellent post, Geek! It's true that the younger you begin the easier it will be to reach your retirement goals. At 31 years old with a small portfolio, I have to be aggressive with saving to reach my goals. I'm glad you included the dividend reinvestment portfolio as well. $11,986.73 in passive income would still be an awesome accomplishment. Thanks for sharing!

ReplyDeleteThanks RTC. This should be a part of finance 101 in school. I wish someone had thought me this back then. Nevertheless I am doing what I can to achieve FI. Keep going strong mate!

DeleteLove the data! That is the lesson I am trying to teach my kids. I made a few mistakes in life and am now trying to catch up. Even if you fail don't give up hope that you can still achieve your goals.

ReplyDeletePeace,

DFG

Awesome DFG. I am happy to know you are teaching your kids the basics of finance. My dad thought me to save but not the effects of compounding. We still have time ... all is not lost. Thanks DFG.

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