The Number
What's your number? Your number is the amount of money it would take to enable you to retire and live off the interest without touching the principal. Your number is the very definition of financial security, and it’s the ultimate goal of every investment plan. We’re going to look at the many ways you can get to your number by saving and investing, and you can use this information to make some important decisions about how to invest.
Let’s say you’re just starting out in a career that will ultimately span 40 years. You’re 25 years old, and your income is $25,000. Over time - with raises, promotions, and job changes - you end up earning four times as much as your starting income, or $100,000 per year. The first question is how much income will you need when you retire, in order to have a comfortable standard of living? Professional financial planners estimate that you will need about 80% of your pre-retirement income when you retire, which works out to $80,000 in this case.
The next question is, how much will you need to have in your account when you retire, so that you can live off the interest? The answer is $1.3 million. Here’s how we got to this number:
| $100,000 |
Income before retirement |
| $80,000 |
Income needed in retirement (80%) |
| 6% |
Expected rate of return in retirement |
| $1,333,333 |
Nest Egg (80,000 / 6%) |
How realistic is it for you to accumulate a $1.3 million nest egg over a 40 year career? The answer depends on two factors: how much are you willing to save, and what rate of return will you get on your investments. Let’s look at each of these factors.
Save More
How much of your income would you need to save in order to accumulate a nest egg of $1.3 million? The answer is 50% That's right - you would have to save half of your gross income every year in order to reach your number by saving. But this isn't realistic. It will be difficult enough just to manage to put away 10% of your income. So let's look at another way to get to the number - by getting a better return on your investments.
Invest Better
Let's go back to saving 10% of your gross income, but now let's increase your return on investments. Up until now we've been assuming that the return on investments is 4%, which just matches inflation. The net effect is that investments have not contributed to our nest egg. But let's see what happens when you increase the investment return to 7% and to 11%. How will that impact the size of your nest egg?
Table 2 Higher Return on Investments
| |
4% |
7% |
11% |
| From Savings |
$270,071 |
$270,071 |
$270,071 |
| From Investments |
$ 0 |
$183,502 |
$758,312 |
| Total Nest Egg |
$270,071 |
$453,573 |
$1,028,383 |
| # Yrs Nest Egg Lasts |
3.9 |
6.2 |
25.3 |
What does this table reveal? It reveals that the rate of return on your investments is critically important to your financial security in retirement. If you earn 4% then all of your investment gains will be wiped out by inflation, and you will be living off principal and your nest egg will be depleted in less than 4 years. If you earn 7% then your nest egg will be a little bigger at the beginning of retirement, but you will still deplete it in 6.2 years. It's only when you earn 11% on your investments that you begin to build a nest egg that's large enough to sustain you for long enough in retirement so that you can be financially secure.
How do you get 11% return on your investments? It's not as hard as you might think. All you have to do is match the average rate of return of the stock market. But the problem is that the average investor only makes 4%, not 11% on investments. Why is this? It's mostly due to poor timing. The typical stock market cycle is long periods of rising prices, interrupted by short periods of declines, usually caused by economic recessions. The average investor waits until the economy is so bad that the stock market is down 20% or more, at which point they get worried enough to sell their stocks. When the economy recovers, they are hesitant to get back in because they are worried about losing more money. So they wait until the evidence is clear that the recession is over, and they get back into the stock market at much higher prices. This poor timing is the main reason why the average investor only makes 4% per year on their investments, while the stock market goes up by 11% per year, on average.
ZenInvestor Premium subscribers learn how to set up their investments to capture the full 11% return.
