What’s the fastest way for younger people to grow their wealth? The answer is to make saving a habit. A solid savings plan that puts away 10 percent of income or more is the most reliable method for growing wealth at an early age. Learning to invest well is also important, but it’s not nearly as important as sticking to a regimented savings plan.
Parents and grandparents encourage children to start saving at an early age. We buy them cute piggy-banks and tell them to put money in it for a rainy day. When our children grow into young adults and start working full time, we tell them to take advantage of their employer’s 401(k) account or similar retirement program, especially if the employer provides matched funds. This is all good advice.
The figure below shows the rate of growth for two retirement accounts. They represent two 20-year-old workers who earned the same $36,000 starting salary and received the same 4 percent per year income increase for 45 years. The red line represents one worker who saved 10 percent of their pay and earned 5 percent per year in returns and the blue line represents the other worker who saved 5 percent and earned 10 percent.
A high savings rate resulted in greater wealth in the early years and a higher rate of return resulted in a higher result in the later years. The inflection point where the lines cross is at age 46 and about $300,000 in savings.
There a few important points to be made in this study:
- It’s OK for young people to experiment with investment ideas — assuming a 10 percent savings rate — because mistakes don’t hurt wealth accumulation too much when there isn’t a lot to invest.
- It’s important for early savers to learn to invest properly during their first 15 years. At about the 15 year point, there is enough wealth accumulated under both scenarios that annual gains from investment have a larger impact on wealth than the amount saved.
- It’s a mistake to continue saving at a low level under the belief that wealth will be accumulated later in life because of higher rates of investment return. Betting on beating the market to fund retirement almost always fails (just ask nearly any state pension fund trustee).
Young people who learn to pay themselves 10 percent per year and learn to invest properly through a diversified portfolio of low-cost index funds will come out way ahead by the time they hit retirement age.
One of my favorite books that highlights this concept is The Richest Man in Babylon by George S. Clason. The book tells how Arkad, a lowly chariot maker, asks for financial advice from one of his wealthy customers in exchange for his services. The customer agrees and explains the principals of saving and investing to Arkad, who follows this advice and becomes one of the richest men in Babylon.
Every graduating senior who is entering the job market this summer should read Clason’s simple 200-page book. I often give this book out as a gift whenever a young person asks for my advice on money. I tell them, “If you read this book and follow the advice, it will make you rich.”