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The Markets July 20, 2012
Young Investors Have the Power of Compounding
Those who start saving for retirement in their 20s can make nearly
double what an investor beginning in their 30s can, because of
compounding, research suggests.
Reported by Corie Russell
Vanguard found that a participant who starts saving for retirement at age 25, based on $1,000 in annual contributions for 30 years with a 6% return, is estimated to have an account balance of $83,802 by age 55 and $150,076 by age 65. A participant who does not start saving until age 35, on the other hand, could contribute at the same rate but not save $83,802 until age 65.
Maria Bruno, senior investment analyst for Vanguard Investment Counseling and Research, said during a webinar that young investors’ challenge is increasing savings early. The power of compounding—or generating earnings from previous earnings—is important to young people, she said.
According to Bruno, although a 3% retirement savings deferral rate is common, it is too low. Twelve to 15% is a more optimal deferral rate for investors. “That can be a lofty goal,” she acknowledged, but she advised investors to start where they can and use automatic escalation if possible.
It is important to implement investment education early, she said. For example, parents can start a college savings fund and show their children how the money accumulates over time. In college, finance classes can make young people more aware of the importance of saving.
Bruno conceded that young people face many competing savings goals such as buying a house, paying for a wedding or their children’s college education, but said retirement saving should still be factored into a financial plan.
Many things can be paid with loans, but retirement cannot, which is why retirement saving must be a priority. A post-graduate with student loans should still contribute to a retirement plan, she stated. This is not to say student loan debt should be neglected, but a plan should be in place to pay off debt while simultaneously saving for retirement. “You don’t want to necessarily shift away from retirement just to pay off student loans,” Bruno said.
Young investors might be hesitant to invest because of market performance in recent years. “Their short investment horizon has been marked by some volatility,” she noted, but emphasized that this is typical throughout history.
Young investors should not focus on market volatility because they are being exposed to it early and can still bounce back. Worrying too much about volatility can cause young investors to avoid market risk and expose themselves to inflation, she cautioned.
Bruno added that young investors should not try to time the market and chase performance. Studies show that investors who attempt this have lower performance than those who pick an asset allocation and stick with it. Portfolios should be broadly diversified with both U.S. and non-U.S. stocks, she suggested.