This is a three-part series on how to make your next million dollars. The key to doing this is PLANNING! There needs to be a “savings” line item in your monthly budget. Unfortunately too many investors are not saving much, if anything at all.
- Part 1 of the series discusses the key behavioral trap investors fall into that prohibits them from reaching this milestone.
- Part 2 describes the assumptions you need to consider when calculating how long it is going to take you to get to that next million.
- Part 3 describes the keys to starting on the path to becoming confident in your retirement plan.
PART 2: How Your Money Grows
When saving for a future goal, you need to know what it will take to achieve it. It involves a variety of factors, including: how much you need to save, what rate of return you’ll need to earn, and how long it will take to achieve your goal. Usually you have at least one of these in mind – but the other factors will also impact your allocated savings. There are a variety of savings calculators online (like this one) that allow you to input your own assumptions for these factors, but it is important to understand how they work and impact each other before beginning to plug in the numbers.
This is, essentially, your starting point. You may be starting with an amount already saved, or you may be starting from scratch. Either way, this will determine how much you need to save.
In doing your budget, you may have already determined how much you are able to save each month. So, all you will need to know is how much you need to earn on your investments to achieve your goal. But, if the required rate of return is unreasonable or involves taking risks that are beyond your tolerance, you may have to find a way to increase your savings amount if you expect to achieve your goal within your desired time frame; or you may have to extend your timeframe.
Conversely, if are dead set on your timeframe and you are willing to assume that your money can earn a certain rate of return throughout that timeframe, these factors will determine how much you will need to save each month. It then becomes your responsibility to budget for that savings amount.
Rate of Return
This is probably the most difficult factor to determine, but it is also the most critical. It really all comes down to risk and how much of it you can tolerate or are willing to take. It’s vitally important to realize that the returns you earn on your money are inextricably linked to risk. The more risk you can take, the higher the returns you should expect. So, risk isn’t necessarily bad if you know how to manage it. And there are specific strategies that can be used to mitigate risk while achieving higher returns.
The keys to minimizing risk are:
- Creating an asset allocation comprised of a big basket of stocks and not trying to pick individual winners.
- Diversifying your portfolio across many different sectors of the economy and across many parts of the globe.
- Rebalancing your portfolio each year by selling stocks that outperformed and buying more of those that underperformed. This will enable to maintain the asset mix that fits your risk tolerance and your investment objective.
When you monitor your portfolio, and repeat these steps each year, you’ll be able to capture all of the returns the market has to offer with minimal volatility.
Note: If you want to factor in inflation, which is a good idea, you would simply reduce your expected rate of return by an assumed rate of inflation. For example, if you expect to earn 8 percent on your money, and you expect inflation to average 3.5 percent throughout your timeframe, your assumed rate of return would be 5.5 percent. It may mean having to increase your savings amount or lengthening your timeframe, but it will give you a more realistic projection.
We’ve already discussed the value of time. There truly is a “cost of waiting” you incur when you put off your savings. The less time you have the more expensive your goals become. However, with savings, it’s never too late to start.
If you have a set timeframe, you will need to adjust your monthly savings amount and/or your rate of return based on the number of years you have to save. If you know how much you want to save and you expect to earn a certain rate of return, these factors will determine how long it will take to achieve your goal.
The following chart from TimeValue.com illustrates how your timeframe and your investment return impacts the “cost” of accumulating $1 million:
Saving $1 Million
Monthly Savings Required Based on Timeframe and Return
|Rate||10 Years||20 Years||30 Years||40 Years||50 Years|
Your goal is the future value you are seeking to create. Using the example of saving a million dollars, that is the future value of what you currently have and what you will be saving over time. When planning your financial future, you need to know the total cost of your goals. For many people, a million dollars wouldn’t be enough to maintain the life style they envision in retirement. Confidence comes from knowing you will have enough to sustain your idea of a good life for the rest of your life, so “the number” should be based on what it will take to do that. It could be a million, or it could be $3 million. Whatever is determined, that becomes your target.
Future value can also be used to determine how much you will accumulate when you know your savings amount, timeframe and rate of return.
Stay tuned for Part 3: Key for Savings Success