The basics you need to know to get started with your retirement plan. Includes: compound interest, asset class descriptions, historical returns, costs information and asset allocation.
2. Compound Interest
Sarah starts saving $500 a month for retirement at age 25 but stops at age 35.
With a 7% annual return she will retire by age 65 with $658,783 after
contributing only $60,000.
Jon waits until he is 35 to start saving $500 a month but he saves until he
retires at 65. He contributed $180,000 to his account over 30 years. With a
7% return he will end up with $609,985 when he retires, even though he
saved more and for a longer period of time. Here are the results:
Assuming Sarah doesn’t stop saving at age 35, but continues until she retires
at age 65, she now has over $1.3 million at retirement. Sarah comes out on
top because she started early and let compound interest do the rest.
3. Asset Class Basics
Stocks: Offer the ability to take part in the
innovation, earnings growth and dividend payouts
of the business world. Higher risk of large losses
come with higher returns over the long-term.
Bonds: Bonds are basically loans that pay you
interest over a set period of time. Stable cash flows
but value can change with interest rates and other
factors like credit quality and maturity.
Cash: Offer safety of principal but little to no
growth after accounting for inflation.
4. Asset Class Returns
Stocks (S&P 500), Bonds (10 Year Yreasuries), Cash (T-Bills) & Housing (Case-Shiller Index)
5. Asset Allocation
Asset allocation is the mix of stocks, bonds and other investments in your
portfolio and is your most important investment decision. Higher risk leads to
higher returns. Historical returns to year end 2012 for a stock/bond mix:
Source: Damodaran
Stocks (S&P 500), Bonds (10 Year Treasuries)
6. Costs Matter
"If there's anything in the whole world of mutual funds that you can take to the bank, it's that expense ratios help
you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds.
Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest
quintile produced higher total returns than the most expensive quintile." – Russel Kinnel, Morningstar
The Average Active Mutual Fund Fee: 1.14%
The Average Index Fund Fee: 0.15%
Assuming an 8% market return, over 30 years:
A 6.86% return net of fees (active funds) would turn $10,000 into $73,190
A 7.85% return net of fees (index funds) would turn $10,000 into $96,516
That’s almost a $25,000 difference because of fees, assuming both earn the
same gross return
Source: Vanguard
7. Lessons?
• Save early and often to take advantage of
compound interest
• Understand the basic asset classes and their
long-term historical returns before investing
• Asset allocation and costs are two of the
biggest factors in your investment
performance
8. For more information visit
www.awealthofcommonsense.com
*Source for all return and graphical data used in this presentation comes from
http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/histretSP.html &
http://www.econ.yale.edu/~shiller/data.htm
Calculations are my own.
