The Millionaire Next Door - wealth formula

[Ag NSX]

I started this thread to break out the discussion about the 'wealth' formula which Lud mentioned in the other thread.

I read this book during my 6 month NSX search back in 1998 and it almost caused me to postpone my NSX purchase. For those who haven't read it, the author basically polls a bunch of millionaires to see what type of spending habits, traits they all have in common.

The formula mentioned was: Age/10 X Income = measure of wealth. So if you were 25yo making $50k, you should have a net worth of $125k to be considered wealthy. I believe that the equity in your home is NOT suppose to be included.

At the time I read the book, I was 26 (I was out of school for 2 years) and should have had $104k. I don't remember exactly, by I think I was halfway there. I knew the NSX would set be WAY back into the 'poor' person category.

One thing I remembered is that most millionaires in this book did not spend more than $35k on a car. This was the one 'rule' that I broke right away buying the NSX. Anyway, revisiting this 4 years later, It's interesting to reread the book to see how many more 'rules' I've broken, and I have, but the lingering memory of some of the things read in this book have caused me to rethink and cancel many purchases.

BTW, I recommend reading Rich Dad/Poor Dad also. Not so much as to follow it completely, but it gets you into a different mode of thinking about work, education, life and how we think about our home.

Kenric

 

[O-Ace]

Interesting...I'll have to check that out

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2001 QuickSilver Corvette Coupe. - Not Bone Stock

2002 Black Acura 3.2 TL/S

 

[lemansnsx]

Originally posted by Ag NSX:
BTW, I recommend reading Rich Dad/Poor Dad also. Not so much as to follow it completely, but it gets you into a different mode of thinking about work, education, life and how we think about our home.

Kenric

Having read both (and others) I highly recommend reading or at least skimming these 2 books and then adopting as much of the philosophies espoused as you are comfortable with. I thought some of it was crap - but we sometimes disagree with things that stand in the way of our toys, etc. A couple of points that you should take to heart are not spending hard-earned capital on things that go down in value and making money work for you instead of getting trapped in the game of always having to work harder to support a more and more extravagant lifestyle. Many of my acquaintances are always in the mode of buying things based on being able to make the payments: IOW, if they can make the minimum payments on the loan they think they can afford the toy. They can't - but you can never tell them that.

Then again, what do I know? I'm not as financially secure as I'd like to be... and there have been a few toys along the way...


------------------
Andrew Henderson
The NSX Model List Page

"We have long acknowledged that enthusiasm for things automotive is a sure
sign of emotional instability if not outright dementia" - Brock Yates

 

[nsxtasy]

I think the idea behind the formula is probably sound. What you have saved should be greater as you age. IOW, you should have save 4 (or, better yet, 8) times your income when you're 40, 5-10 times your income when you're 50, etc.

However, I don't think the formula can be reliable for someone in his/her twenties. Many people are just starting out work, often at a low salary (that will increase later) and often with education debts to repay. These circumstances are not conducive to saving.

 

[Edwardo]

I have heard quite a bit about this book. I defianately want to read it.

I agree with saving your money and being frugal whenever possible. However, I don't think that spending an enormous amount of money for an NSX(or any toy/object) is necessarily a foolish move. I think it is foolish to buy a new NSX every three years because it is the latest and greatest iteration.

If you are passionate about something I think you should spend some of your money on it. There is a limit to the latter point. I guess I will have to read the book to see what the author feels said limits are.

 

[Bilulan]

Originally posted by nsxtasy:
I think the idea behind the formula is probably sound. What you have saved should be greater as you age. IOW, you should have save 4 (or, better yet, 8) times your income when you're 40, 5-10 times your income when you're 50, etc.

However, I don't think the formula can be reliable for someone in his/her twenties. Many people are just starting out work, often at a low salary (that will increase later) and often with education debts to repay. These circumstances are not conducive to saving.

I completely agree with you.
If you think about just making $50k a year from age 30 to age 40 (even without a single increase from year to year) you earn $500K. Maybe 350-380K after taxes. This money is significantly greater than money you earn from age 15-20 and ages 20-30 and can be put aside for more investing. When your starting out, there are many expenses that prevent growing the net worth figure. (Furniture/furnishings, getting over the rent hump and saving for that initial home/apartment.)

I know I'll never forget the engagement ring/wedding expense. (Caused me to sell my first NSX)

 

[hejo]

Originally posted by nsxtasy:
I think the idea behind the formula is probably sound. What you have saved should be greater as you age. IOW, you should have save 4 (or, better yet, 8) times your income when you're 40, 5-10 times your income when you're 50, etc.

However, I don't think the formula can be reliable for someone in his/her twenties. Many people are just starting out work, often at a low salary (that will increase later) and often with education debts to repay. These circumstances are not conducive to saving.

I agree Ken this equation is really hard for young folks. I'm not sure what people's factor shoul be as I look at it slightly different. Maybe I'm warped or something but here's how I look at things.

Once again I'm not a CPA, accountant, financial planner, stock guru, etc. I'm just a guy who started with nothing and has had to work his butt off to get what I have now. So here's my MOB view of planning for a life that "depends".

I figure I'm going live at least into my 80's and most likely into the 90s. Both my fathers’ parents are still with us at 93. My mothers side passed in their 80s. So my plan is to retire between 58 and 62 even though the Feds will get a piece of me. That means I'll be kickin around hopefully between anther 25~30 years. I also want to have the same standard of life style I have now.

So let's just say for grins I want to have lifestyle that comes with an average income in today terms of $240k. Let's also say for grins that inflation is maintained to around 3%. Let's also say conservatively you can average around an 8% ROI on investments. To make math really easy let's put these two together and say the net ROI on our conservative investments is going to be ~5%.

How much do I need in a portfolio to supply a $240k/yr income for 30 years with no money left at the end? Pulling out my nifty HP 12C it looks like I need ~$3.7M. Hmm...

Now this is really simple and isn't exactly what you'd plan for because how many 70+ year olds need $20k a month to live? What is more realistic is to consider that by the time you're 70 you'll most likely be downsizing and your spending habits are going to change. In fact I doubt you'll be out partying all night smoking $25 cigars and drinking $20 shots of grappa. However some of us will try

though... Hugh, Frank, Dino my buddies...

So a more realistic approach is to adjust the cash flows by the periods you'll go through when you retire appropriately reflect what you think you'll need at these different stages in life. When you take this approach the nut you needs drops significantly.

I don't know if any of this makes any sense or not but I'd say if you don't have at least a cool $1m++ in the bank by the time you're 60 life is going to be like when you lived with your parents. Myself I'm not looking to repeat that experience so I'm shooting to exceed that by a big margin.

 

[nsxtasy]

I've heard it said (another one of those rule of thumb generalizations) that when you earn an income at some particular level, in order to retire you need to accumulate enough to have about half that amount of income still coming in.

 

[Lud]

I still believe this is a good formula no matter what you age, with the exception of maybe the first year out of school. And it doesn't matter what school that is - high school drop-out, college grad, or phd.

You just need to view it from the perspective that it provides a snapshot only, not a prediction of where someone will end up. I do not think I explained this well last time, so please see my example below.

Anyone should be able to look a few years down the road and make a reasonable estimate of their income. You can keep running that formula for various scenarios of income and see how much you need to be saving to get on the path to financial independence.

Someone who stays in school longer DOES need to make up for the fact that they spent those years not earning at their potential.

It's like looking at a map. Say two people start in New York, NY and both want to drive to San Francisco. It's around a 3000 mile trip. If one person starts a day ahead of the other, that second person is going to have to travel a good bit faster if they want to reach the destination at the same time as the first person.

And if you look at the map and realize you are in Atlanta, GA (i.e. you have been spending a lot) then you can say "Hey, I've traveled quite a distance but I'm not really headed towards my goal! I'm going to have to make a course correction if I want to get there. And if I want to get there anywhere near when I originally intended, I'm going to have to make up a lot of time."

Regarding the comments about reduced spending in old age - that is usually by necessity, not desire. Sure you may not be out all night partying when you are 70, but you may want to travel more. Or you may want to be able to put some grandkids through school. Or you may need to pay six-figures a year for quality assisted living for you and/or your spouse, or even a disabled child or grandchild.

The point is not simply to be able to support yourself in a decent manner from your 60s until you retire. The point is to become financially independent as early as YOU wish to. At that point you can continue to work if you want to, not because you have to.

 

[hejo]

Originally posted by Lud:
Regarding the comments about reduced spending in old age ...The point is to become financially independent as early as YOU wish to. At that point you can continue to work if you want to, not because you have to.

I agree with you Lud the objective is to become financially independent. Also I did a projection of what I believe my income will be at retirement using age 60. The formula is damn close to what I plan on having. The other thing that may help the younger folks is to income average over the last 5 years.

My comments about what you need as you get older comes from watching my grandparents and parents go through the process. Both of them are in the position we'd all like to be in, being able to do whatever they desire and being well taken care of.

Travel would be nice if you're in good health. It's really not a friendly experience anymore. Recently flying out of Tampa they actually searched a 80+ yr old women in a wheelchair. I was searched too and the only thing I can think of is because we were in 1st class. She could hardly stand and barely walk. I'd say everyone around me thought it was crazy.

Maybe a nice RV for $400k would work...while you're in your 60s but I have a hard time seeing that into the 70s and beyond. Also the folks I know that are doing this usually stop after a few years because they've been everywhere they want to go.

As far as the grandkids... the way I figure it pay back is a bitch. They'll get loud toys, lot's of candy, and cool vacations with the grandparents just to set the bar really high

... just kidding ... maybe

I also figure assisted living is include the yearly income requirements and it's something people need to seriously consider as we're living longer these days. My grandparents entered this phase last year. Basically they sold the property off which will fund this for many years. No reason to have the property if you're in assisted living.

Oh and one other thing... my grandparents and parents all beleive in leaving only a little for the grandkids. Not so much to where they will not learn the value of work and money. No free rides.

 

[Nsxotic]

I think the formula way out of whack. It's grossly heavy in most 25-40 year old people and grossly low in most 60-70 year old people.

Ex. Are you telling me that a 60 year old person that makes 50k yr. is now able to retire on the 300k he 'might' have by now? And are you also sayng that a 30 year old making 50k will be able to have a 150k net worth? No way in either case. In fact, it's nearly impossible to do either.

I'm soon to be 33 and if I had saved EVERY single dollar that I netted over the last 5 years, I still would be 38k short of fullfilling this formula. So now we see why this is completely ridiculous.

 

[Lud]

Remember that the age / 10 * annual income is the "OK" number. Twice that is the "doing well" number.

If someone is 60 and earns $50k, they should be able to retire and not really change their lifestyle if they have $300k net aside from equity in their home. They should have their home paid at that point, so they can draw $30k a year from their investments and probably maintain a similar lifestyle to when they were earning and paying on their mortgage and not kill their principal. Again to being "doing well" they would actually have $600k net worth, on which they should be able to very comfortably maintain their current lifestyle. And if they waited until they were 62 to retire and got a 5% raise each year, their "doing well" number would be over $680,000 + equity in their home. Certainly they should be able to maintain the same lifestyle at that point.

Yes, it is possible for someone who is 30 years old and earning $50k/year to have $150k net worth outside equity in their home. Is it common? No. But if they saved AND INVESTED $500/mo at the average stock market rate of return since they were 18 they should be there.

If they went to college until age 22 instead, then they are not likely to be there no matter how aggressively they saved unless they lived at home, which shows that they need to to make up for the time spent in school.

Or if, instead, they always buy the most car or house they can make the monthly payments on and don't have any left over to save and invest, they won't be there. But they will be able to see how much more they need to save in the future to GET there.

This is not to say someone who is 30 and doesn't have that much net worth has screwed up or needs to worry - that situation is normal, as most people's peak earning and saving/investing years are in their 40s and 50s and as others have noted the 20s and 30s are when most people have a lot of expenses. But I think it does show where they need to GO to get to their intended destination.

If someone is in their early 30s and earning a good bit over $100k a year and expects that to continue to increase for the next 25+ years, they are going to have to have several million dollars net worth when they are 60+ to retire and maintain their lifestyle.

 

[Nsxotic]

Thanks Lud, but I really don't see it at all. How do you explain that I couldn't have spent one cent over the last five years and I still would've been short of this formula?

Here are some numbers to help get an answer because this is insane. Someone at 33 years old making 120k will take home about 70-75k. This persons 'ok' number would be 396k. He has only taken home ~360k total over the last 5 years. He's 36k short of the 'ok' number and must be living under a bridge and eating from garbage cans because he can't have spent one cent!. I don't know how he kept his job for 5 years without being able to shower regularly, but..... So HOW is this even close to a possible formula without getting 'fed' a lot by family or inheritance or lottery? The way I see it, this person 'may' have been able to save about 10-15k/yr.(if he is cheap and spends like he makes 50k/yr.) equalling 50-75k. If he got lucky on a couple investments, he might make that into 100k. THIS would be a great job in my eyes and that guy is doing quite well. Hmmmmm?

 

[Ag NSX]

I just reread the section on this in the book and it is networth. It doesnt mention not including home equity at all. So let's try this example, based on Chicago real estate.

An average college grad is 23 yo. Let's say this person gets a job paying $50k and has $20k in college debt. 50k would net him about $33k take home. By the time he's 30 (assuming he got no raises), he's taken home 7 X $33k = $231k, minus $20k in college debt (assume no interest), so $211k.

The formula says that he should have $150k at this time.

Let's assume this college grad saved 15% of his take home pay every year. That's $5k per year. If this was invested and earned 10% a year, he would have $47k.

Let's also assume that this person purchased a $110k condo seven years ago, and was able to maintaion saving 15%. Then this condo appreciated to $150k and he now only owes $90k on it.

If this is the case, he would have a net worth of about $100k.

This is short of the formula AND this person saved his money too. I think the point of doing this exercise is to realize that saving 15% is not enough, and that you must make the money work for you in order to achieve financial independence. The formula is not meant to be easy to achieve. I believe the formula is a good goal to shoot for.

 

[hejo]

Originally posted by Nsxotic:
Here are some numbers to help get an answer because this is insane. Someone at 33 years old making 120k will take home about 70-75k. This persons 'ok' number would be 396k. He has only taken home ~360k total over the last 5 years.

Two things... what happened between 21 and 28 as far as saving? Also what is the average salary during this time?

 

[Darkcyd]

Originally posted by hejo:
I agree Ken this equation is really hard for young folks. I'm not sure what people's factor shoul be as I look at it slightly different. Maybe I'm warped or something but here's how I look at things.

Once again I'm not a CPA, accountant, financial planner, stock guru, etc. I'm just a guy who started with nothing and has had to work his butt off to get what I have now. So here's my MOB view of planning for a life that "depends".

I figure I'm going live at least into my 80's and most likely into the 90s. Both my fathers’ parents are still with us at 93. My mothers side passed in their 80s. So my plan is to retire between 58 and 62 even though the Feds will get a piece of me. That means I'll be kickin around hopefully between anther 25~30 years. I also want to have the same standard of life style I have now.

So let's just say for grins I want to have lifestyle that comes with an average income in today terms of $240k. Let's also say for grins that inflation is maintained to around 3%. Let's also say conservatively you can average around an 8% ROI on investments. To make math really easy let's put these two together and say the net ROI on our conservative investments is going to be ~5%.

How much do I need in a portfolio to supply a $240k/yr income for 30 years with no money left at the end? Pulling out my nifty HP 12C it looks like I need ~$3.7M. Hmm...

Now this is really simple and isn't exactly what you'd plan for because how many 70+ year olds need $20k a month to live? What is more realistic is to consider that by the time you're 70 you'll most likely be downsizing and your spending habits are going to change. In fact I doubt you'll be out partying all night smoking $25 cigars and drinking $20 shots of grappa. However some of us will try

though... Hugh, Frank, Dino my buddies...

So a more realistic approach is to adjust the cash flows by the periods you'll go through when you retire appropriately reflect what you think you'll need at these different stages in life. When you take this approach the nut you needs drops significantly.

I don't know if any of this makes any sense or not but I'd say if you don't have at least a cool $1m++ in the bank by the time you're 60 life is going to be like when you lived with your parents. Myself I'm not looking to repeat that experience so I'm shooting to exceed that by a big margin.

Just thought I'd put in my two cents as a financial planner. =)

You're on the right track as far as your reasoning behind the determination of your income needs for post-retirement. However, you're not taking into consideration several things.

1. Your total asset base saved by the time you retire is going to need to be higher than 3.7M. This is because like you mentioned, you will be living on this income for another 20-30 years. What is a $240k annual income the day you retire, is not going to be a $240k annual income 10, 20, or 30 years later in retirement. With an average annual inflation rate over the last 50 years of roughly 5% or so, you can bet on the $240k annual not getting you nearly as far as you think it will. And it will continue to decrease in value throughout your retirement.

2. You may like to think that your cost of living will decrease in retirement because you will most likely have paid off your home by then and incur less living expense. However, it should be noted that your entertainment expenses will probably increase whether it be for vacations, travelling to see your family more often, and exploring new hobbies now that you have so much more free time. But more importantly, you must include expenses that you haven't yet foreseen. You will likely start to worry about protecting your estate for future generations meaning you will incur larger life insurance and trust fees. Your health will no longer be as strong and your health insurance will cost more. Not to mention that with medical advances prolonging our lives these days, purchasing long-term care insurance will be necessary as well. It is not likely that your expenses will decrease significantly post-retirement. Most industry experts advise that you will need at least 80% of your income just prior to retirement in order to maintain your standard of living.

Hope this helps. =)

 

[milz50]

Let's try an exercise to see why there are such differing opinions using this formula.

For example, suppose there are two people who wish to have the same savings of X by age 60. One of the people invests a sum of money (Y) at age 20. Another invests a sum of money (Z) at age 40. Should we assume, ceteris paribus, that for each of these people to reach the same goal of X by age 60, the 40 year old has to invest only twice as much as the 20 year old?

The answer is no. Assuming a 9% ROI, the 40 year old would have to invest almost 6 times as much as the 20 year old. I arbitrarily selected 9%. A greater return would increase the factor of 6 and a smaller return would decrease the factor. Let's call this the Late Savings Penalty Factor (LSPF).

If we were to apply the 'millionare formula' to the above example to solve for the ratio of expected savings for the late investor to the expected savings for the early investor we get:

Late Saver Expected Savings = 40/10 * incomeAt40

Early Saver Expected Savings = 20/10 * incomeAt20

If we take the ratio of the two we end up with:

2 * incomeAt40/incomeAt20.

This means that according to the 'millionare equation', the late saver should have a Late Savings Penalty Factor (LSPF) of 2 * incomeAt40/incomeAt20. If we assume a fixed 3% income growth for the 20 years, the LSPF is 2*1.8, or 3.6.

Thus, given our assumptions, the LSPF factor is much less (3.6 vs. 6) using the 'millionaire equation' versus compounding an invested lump sum.

Realizing this, we can go one of two ways.

1) We can accept our assumptions (income growth and investment ROI) as reasonable and say that the 'millionaire equation' overstates necessary savings for younger savers versus older savers.

2) We can alter our assumptions to discover scenarios where the two methods are equal in this example.

To make the 'millionaire equation' have a LSPF of 6, which was derived using the investment compounding, the income of the 40 year old must be 3 times the income of the 20 year old. An annual salary increase of between 5% and 6% would yield triple the income in 20 years.

To adjust our investment calculation to have the 3.6 LSPF derived using the 'millionaire equation' with a salary increase of 3%, the investment ROI would need to be about 6%.

I hope this can help us see where there are some differences in opinions.

Many times when one attempts to simplify a formula (like Stanley/Danko are doing) , the reliability breaks down in extreme circumstances. This formula gives bizarre results when the subject has received substantial income increases on a percentage basis, etc.

Einstein's theory of relativity debunked Newtonian mechanics, but Newton's formulas are still used to simplify calculations. Physicists know which contexts to apply each equation.

Likewise, through this discussion, we are learning which scenarios to apply this equation and when we should search for a better solution.

BTW,

Todd, I agree that the formula is weak. I have been out of school for almost 4 years, but yet I'm supposed to have saved more than I have earned in my life. This is especially difficult since the S&P and Nasdaq are lower now then they were at my graduation.

 

[Lud]

Originally posted by Nsxotic:
Thanks Lud, but I really don't see it at all. How do you explain that I couldn't have spent one cent over the last five years and I still would've been short of this formula?

Let me start by saying I am not a financial planner, and the numbers below are quick estimates.

That being said, I think you are focusing on the wrong numbers. As hejo said, what happened to the TEN years prior to 5 years ago? To make the formula numbers you would have to have saved that entire time. Nobody earning a high salary is likely to be able to hit their numbers with their last 5 years income unless they are really young.

Going to college sets most people back. That is a fact of spending time in school instead of earning. If someone goes to college, they are going to have to save and invest more at some point after college to make up for it.

You said you did not think the guy who is 60 years old making $50k would be able to make do with $300k net worth. Let's look at what it will take for you to be in the same position as him when you retire with regard to maintaining your style of life.

At 33 you are grossing $120k. If your salary increases 5% a year, you will be grossing $448k when you are 60. This sounds like a lot now, but we are talking 27 years in the future. 27 years ago (1975) $120k was a lot of money too! In 1975 someone earning $36k was earning the equivilent of your $120k today.

Anyway, to be in the same position as the hypothetical 60 year old earning $50k/yr with $300k net worth outside of equity in his home, you would need 60/10*$448k which is $2.69 Million. If you want to be in a "good" position you want twice that, or $5.38 million.

If you do not see a clear path to those numbers from your current position, that should be a red flag that you need change something if you want to meet your financial goals (if those are your goals).

If you want to be in a position where you are at least as well off as that 60/$50k/$300k guy, please explain to me how you are reasonably going to get to the numbers above from your current position if you don't change your spending/saving habits...

My quick estimate is that starting this year with $80k net worth, if you save and invest 7% of your gross pay every year (assuming your gross income continues to grow 5% annualy), and earn 10% a year average on your investments, you will be at around $2.70M by age 60 which is just over the "low" number of $2.69M. To hit the "good" number of $5.38M you need to be saving/investing more like 18.5% of your gross every year from now until you are 60 at a 10% average annual return.

So let me ask you this. Instead of focusing on what you feel to be a fault with the formula, let's come at this from the back end. Can you lay out how you intend to achieve those numbers without changing your current spending/saving pattern? Or can you show how you do not need to hit those numbers to maintain your lifestyle when you retire?

 

[Lud]

Originally posted by milz50:
Many times when one attempts to simplify a formula (like Stanley/Danko are doing) , the reliability breaks down in extreme circumstances.

You are right, it is an overly simple formula and as I have said about 10 times, I do not think it is useful to try and take one snapshot and use it to predict your entire life. In my very first message I also said that large variances in income require averaging the last few years to get a reasonable number. You can find extreme exceptions to any rule of thumb, but I don't think more than 10% of the people in this country would be excepted. Probably a lot less.

The problem I see with your examples is that you are trying to use it on one-time investments at various ages when it is meant to gauge ongoing savings and investments throughout your lifetime.

If used to gauge various scenarios I think it is pretty useful. See Todd's situation in my previous message.

Todd, I agree that the formula is weak. I have been out of school for almost 4 years, but yet I'm supposed to have saved more than I have earned in my life. This is especially difficult since the S&P and Nasdaq are lower now then they were at my graduation.

Don't you agree that the fact that you are behind your number means that you will need somehow make up for it (either through increased savings or increased return) in the future, assuming you want to be financially independent? Doesn't that make it a useful rule of thumb?

[This message has been edited by Lud (edited 28 April 2002).]

 

[Ag NSX]

I agree with Lud here. Insteading of focusing on the weaknesses of the formula, use it to ask yourself am I saving enough. Don't use it as an absolute, but as a goal or gauge. If I made $50k, I'd be ok but if I got a raise today to $60k, then I'd be behind, does it mean I'm not saving correctly? No, but my net worth goal just increased and I should strive to reach it.

Maybe we should do a poll on this forum to see how many people here actually meets this formula. It would be very interesting to see if its 50% or more. I personally do not, but I have many friends who do at about 31yo. So this formula is achievable but difficult. But who said financial independence was easy?

 

[milz50]

The problem I see with your examples is that you are trying to use it on one-time investments at various ages when it is meant to gauge ongoing savings and investments throughout your lifetime.

I used a lump sum investment to make the calculations easier. If I am understanding you correctly, you are saying that periodic investments in lieu of a lump sum investment will make the 'millionaire formula' more sound.

My gut feeling after reading this was 'Wow, he is right- I screwed up my making this to easy'. However, when running the numbers, I still believe that my example is applicable. IOW, the actual results of a periodic investment versus a lump sum payment are counterintuitive.

Let me show my work (all calculations done via MSN's savings calculator at the URL: )http://moneycentral.msn.com/Investor/calcs/n_savapp/main.asp)

Person A: investing a lump sum of $100,000 for 20 years at a return rate of 9% (post-tax) yields ~561K.

Person B: investing a lump sum of $100,000 for 40 years at a return rate of 9% (post-tax) yields ~3,140K.

Using the lump sum method, the second person will have saved 5.60 times as much, or IOW will only need about 1/6th the initial investment to reach the same goal.

Using a fixed periodic investment:

Person A: investing $1000 monthly (with no initial deposit) for 20 years at a return rate of 9% (post-tax) yields ~639K.

Person B: investing $1000 monthly (with no initial deposit) for 40 years at a return rate of 9% (post-tax) yields ~4,219K.

Using the periodic investment method, the second person will have saved 6.6 times as much.

Using those samples, it appears that a fixed periodic investment with further penalize the late saver and, thus, the 'millionaire equation' is even a worse guage when using real-world type of savings patterns.

Again, you can say that I am simplifying the example by expecting a fixed periodic savings. In actuality, one's periodic savings amount is more than likely going to increase. I don't believe that using an accelerating periodic payment will invalidate my example. I think (although I didn't run the numbers) that it will further support my position.



[This message has been edited by milz50 (edited 28 April 2002).]

 

[Nsxotic]

Thanks Lud for a well thought out answer. Those numbers I mentioned are not mine but mathematically yield the same percent and results, so thanks. Here's my last question, and forgive me for sounding naive. What do you all mean by 'investing' when you talk of numbers like 10% return? My savings account gives me about .5-.75% or $10-$12 per month. So I pick up just over $100 per year. I have a 401k but it's down 17k from the total I have put in over the last 4 years when I started it. So that's an ugly %. My checking account pays me nothing. And that's it. Where else to 'invest' that the money can be liquid and not held hostage until I'm 60 yrs. old? By the way, I do not plan to work until I am anywhere near 60!! Yikes! I hope to retire by 45-49. How's that for a twist in my failing formula? Thanks again.

 

[Lud]

Originally posted by milz50:
Using a fixed periodic investment:

You bring up some important points to consider, but I have a problem with using a fixed investment amount. Sorry if my objection seems like a moving target! I am not trying to keep jumping around on you.

I think it is more realistic to assume most people are going to try to invest a % of their income rather than a fixed amount every month which never changes their entire life.

Most people's income goes up through their 20s and 30s, and peaks in their 40s and 50s. Also, if they have saved appropriately for their children's education, by the late 40s and early 50s they should have considerably lower relative fixed expenses. For example, that mortgage payment 20 years later is relatively much lower due to inflation even though the actual amount is unchanged.

I would be interested to see you re-run the numbers using investment as a % of typical gross income for various people through their earning years.

[This message has been edited by Lud (edited 28 April 2002).]

 

[Lud]

Originally posted by Nsxotic:
What do you all mean by 'investing' when you talk of numbers like 10% return?

Again I am not a financial planner and I'm certainly not going to try and write an essay on investing here. But here are some of the really fundamental basics....

Savings accounts - They are a waste. A savings account does not even keep up with inflation so you will effectively have less and less money the longer you just leave it in there. It IS good to keep a-few-to-several months expenses in cash just for emergencies, but you don't want to look to it as an investment. You might consider a money market account or fund instead to get a better return than a straight savings account while keeping it extremely liquid.

Stocks - In general, the return on the stock market for the last 75 years averages to about 11% annually. Sure there are up and downs, but if you are in it for the long haul (and if you are in your 30s, you should be), it averages out pretty well. If you are not very familiar with the market, I would not really recommend picking your own individual stocks for the most part. Consider a financial advisor who can recommend some index funds or something.

Real estate - This is more of a hands-on investment and subject to market swings, etc. If you think you might be interested, do some research. It has worked very well for lots of people, but it takes time and there is risk.

There are many others! Do some research on the websites of respected financial companies or talk to a financial planner.

Obviously when you get closer to retirement you probably want to move some money into less volatile investments such as....

Treasury securities - Basically the government is borrowing money from you and guaranteeing a return. Bonds, T-notes, T-bills, etc. Extremely secure, but return varies. Shop it around vs. other options.

CDs - Low yield but also very low risk. Shop rates vs. treasury securities.

Bond funds - Like a stock fund, but made up of corporate bonds. A little more risk but usually fairly stable.

There are many others! Do some research on the websites of respected financial companies or talk to a financial planner.

Yikes! I hope to retire by 45-49. How's that for a twist in my failing formula? Thanks again.

Yikes is right. If you are looking to retire that soon, you need to seriously sit down with a financial planner and figure out how much money you are going to need to whatever lifestyle you want to live and how you are going to get it. Certainly it is possible, but you will probably have to make some sacrifices at least in the short term. The sooner you do this, the easier it will be.

The basic theme of my message here is - find a good financial planner and get planning. It has been my experience that the best way to find a good personal financial advisor is to ask for a recommendation from a highly regarded accountant or attorney.

It would probably help if you spent some time familiarizing yourself with the basic concepts and terms before your first meeting with an advisor. That way you will make better use of the time you are paying for instead of having to get them to explain everything from scratch. But make sure you DO understand everything they are saying even if that means they do need to explain a lot. There are a huge number of resources on the Internet to educate yourself on personal finance concepts and jargon. Anything from the website of any major financial company to third party sites like www.msn.com or www.cnnfn.com or www.fool.com

 

[nsxtasy]

This is all great advice. I think it's good to focus on the advice rather than the formulas - not that the formulas are wrong, but that they may point out the need for changing your plans (or even developing plans in the first place). Financial security doesn't come about automatically, by magic. It happens in part from good income and in part from good planning.

I think the biggest mistakes people make are (a) not saving enough (or anything), and (b) not starting their saving early. While this statement is probably pretty obvious, its importance cannot be overstated (nor can the unfortunate consequences for those who ignore it).

IMO the very, very best way to start a savings plan is to take advantage of (and maximize) every possible opportunity for tax-deferred savings, such as 401k plans, IRAs, Keogh plans, etc. There are two beautiful features of these plans: (1) you can have the money deducted before it ever hits your checking account and tempts you to spend it; and (2) it lets you make money on the government's share; for every dollar contributed, you have a dollar invested for many years, instead of paying say 30 cents in taxes right away and having only 70 cents invested. That's not to ignore other savings and investment opportunities beyond these, but I think this relatively simple step (which many people ignore) will go a long way towards reaching retirement goals.

$.02, compounded annually