[One often runs across articles in the popular press that purports to show how much ahead one can get in the retirement game by starting to save 10 years early. While establishing a savings habit early and allowing time to do its compounding magic are worthwhile goals, these articles overstate their case by ignoring the time value of money. It is true that investment returns compound over time but at the same time inflation is forever eating away its value. When you account for investment returns but don’t subtract the effects of inflation, you end up with a very distorted picture. A recent post on this topic by Michael James reminded me of this post that was first published here in June 2005. Note the overly optimistic and rather naive assumption of a 9 percent real return.]
Fellow blogger JLP recently posted about the advantages of investing early in life. By starting early, we can allow compounding to work its magic. Time literally is money. However, along with our investment, inflation is also compounding and eating into our returns.
So, I took JLP’s numbers and plugged them into Excel and added a twist: I am assuming annual returns of 12% and an inflation of 3%. Here are the results:
Early Bird, who started investing $3000 every year starting at age 25 has a portfolio of $143,651 at age 40. But, instead of $48,000 in nominal dollars she has actually invested $62,284 in real terms. Actual return is 230% compared to a nominal return of about 300%.
Slow Poke, who waited till 30 and invested $3000 every year thereafter until age 40, has a portfolio of $69,399. He has invested $33,000 in nominal terms but only $39,576 in real terms. Slow Poke’s actual return is 175% and nominal return is 210%.
Admittedly, Early Bird has a big headstart. At age 65, she will have $2.44 million whereas Slow Poke will only have $1.17 million. Starting to invest early pays rich dividends, only it is a little bit less than we think.
