Long-term compounding is truly the eighth wonder of the world.
For those seeking financial security in retirement, there’s a saying all young people should take to heart: Time in the market is far more important than “timing the market.” In other words, one doesn’t have to invest vast sums of money to reach a healthy retirement, provided you start early and contribute consistently.
Investing even modest sums early on in one’s working career allows those meager savings to benefit from more years of compounding earnings and dividend payments. And if you deposit these savings into a tax-advantaged IRA or 401k plan, those compound earnings can grow without your having to pay capital gains taxes.
Here’s how investing just $6.66 per day can lead to a $1 million retirement.
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The miracle of the stock market
Over the long term, the U.S. stock market has appreciated roughly 10% per year. While the return in any particular year can vary wildly, from huge gains to stomach-churning declines, those who stuck with U.S. stocks over the long term have done exceedingly well. That 10% return beats out all other asset classes or at least all other asset classes that are easily accessible to the average investor.
Ten percent may not sound like much, but if your savings compound at that rate over the span of decades, a small amount of money can grow into a considerable retirement nest egg.
$1,000,000 by 65? No problem… if you start at 25
Just what can 10% returns get you? How about $1 million in retirement, with just a modest $6.66 investment per day? The math is simple but remarkable. If the stock market appreciates at a 9.62% average return over the next 40 years — slightly lower than the recent 30-year return of U.S. stocks — it would only take a $200 monthly contribution, or roughly $6.66 per day, to reach $1 million.
That means if you merely start contributing $200 per month, or $6.66 per day, at age 25, you will have $1 million by age 65. The total contribution over those 40 years would only amount to about $96,000, with the remaining $904,000 coming entirely from market gains and dividends.
That assumes no tax leakage or management fees, of course. However, these days it’s easy to invest in a broad market index such as the S&P 500 or a total market index with extremely low management fees. For instance, the Vanguard S&P 500 ETF (VOO 0.08%) and the Vanguard Total Stock Market ETF (NYSEMKT: VTI), which track the S&P 500 index and the total U.S. stock market, respectively, each charge just 3 basis points in management fees, which is close to nothing.
Image source: Getty Images.
Sitting in the shade in retirement
As Warren Buffett once said about long-term investing: “Someone’s sitting in the shade today because someone planted a tree a long time ago.”
Indeed, the above example shows how even market-average returns can grow the seeds of small daily savings into a redwood tree-like nest egg.
And if average returns can turn just $6.66 per day into a $1 million retirement, just think how easy retirement would be if you can achieve above-average returns.
That’s what we attempt to do at The Motley Fool with our Foolish investing philosophy: Find the very best-run companies with significant or emerging competitive advantages, run by excellent managers, and hold these winning companies for the long term to let the miracle of compounding do its work.
For instance, if, through good stock picking, you can compound your portfolio at a 12% rate instead of a 9.6% rate, that $200 per month would reach nearly $2 million over 40 years — double the total of the original gains. So, what looks like just a slight improvement in annual returns can add up to a much greater end result when compounded over many years.
But no matter whether you choose to invest in low-risk, low-cost index funds or try to outperform by picking your own stocks, the important part is to invest as early as possible and to keep up regular contributions. That’s especially true if your employer offers to match your contributions in a tax-advantaged retirement plan.