Guest Author - Reshma Vyas
How long before you become a millionaire? This is always a fantasy-type scenario; a whimsical, exciting question to ponder during a lazy weekend but one which at its core is remarkably insightful.
Here are 3 “real-life” scenarios for individuals; aged 14, 31 and 50 respectively. The following assumptions apply:
• Each individual opens a separate account in the same investment vehicle.
• Each begins with an initial investment of $3000.
• Each contributes $100 monthly.
• The rate of return on the investment is constant at 6%.
• The yearly rate of inflation remains constant at 3.0%.
Scenario 1. Grady age 14.
Results: Grady will reach his goal of one million dollars in 64 years, at age 78. However, adjusted for inflation, the purchasing power of his million dollars will be almost $151,000.
Scenario 2. Marvita, age 31.
Results: Marvita, too, will reach her goal of becoming a millionaire in 64 years at which time she will be 95 years old. Adjusted for inflation, the purchasing power of her million will be almost $151,000.
Scenario 3. Cora, age 50.
Results: It will also take Cora 64 years to reach her goal of becoming a millionaire. Let us hope that Cora is able to live to a ripe old age of 114 years!
How Can Marvita and Cora Catch Up?
Now what can Marvita and Cora do in order to catch up to Grady who will have his million dollar nest egg at age 78?
Analysis of Scenario 2: Marvita’s Situation
In order for Marvita to become a millionaire starting with only an initial $3000 investment, she will have to save considerably more on a monthly basis. If she discontinues cable television, reduces her personal spending which includes cutting back on daily, multiple treks to a pricey gourmet coffee shop, she can increase her monthly savings by an additional $150. She will then have $250 to invest monthly. She will continue to earn 6% on her investment. In 50 years, at age 81, all things being equal, Marvita will reach her goal of one million! Adjusted for inflation, the purchasing power of her million will be slightly over $228,000.
Analysis of Scenarior 3: Cora’s Situation
Cora’s case is particularly sad. In order for Cora to reach millionaire status, she will have to do 3 things:
• Increase the amount of her initial outlay of capital.
• Dramatically increase her savings.
• Generate a higher rate of return (above 6%) on the investment.
Cora managed to come up with an extra $2000 to add to her pool of $3000. By drastically curbing her household expenses, taking public transportation to and from work and brown bagging her lunch to the office, she is able to increase her monthly savings to $350. The initial amount of $5000 is placed in an investment earning a 12% rate of return. She also contributes an additional $350 monthly towards the investment. Cora, finally through many years of creatively scrimping and saving, manages to catch up to millionaire status. She becomes a millionaire in 28 years at age 78. Adjusted for inflation, her one million will be worth a little over $437,000.
What These Scenarios Can Tell Us
Obviously, as we can clearly surmise from Grady’s situation, it is vital to save and invest as early as possible. In such a situation as Grady’s, there are 3 distinct advantages:
• Time is our best friend for building seemingly “effortless” wealth through compounding. Grady’s money did not have to work as hard as Cora’s.
• Unlike Marvita and Cora, Grady did not have to go to uncomfortable lengths to increase his savings or give up anything. He was quite content to contribute only $100 monthly towards his investment.
• Unlike Cora who was in a particularly difficult situation due to her late start, Grady did not have to increase the amount of his starting capital. His $3000 initial investment was more than enough for him to cross the finish line at a leisurely pace and collect his one million dollars.
• The risk to reward ratio worked to Grady’s advantage. Grady’s investment, although producing 6% rate of return, still enabled him to earn a million dollar nest egg by age 78 with far less risk. In comparison, Cora had to make up for her late start by taking on an inordinately higher risk; her 12% rate of return was double that of the rate which Grady and Marvita earned on their respective investments.
Obviously these models are highly simplified in order to highlight the key magnitudes to wealth-building. These are the value of thrift, intelligent financial planning, thoughtful analysis on risk versus reward, the importance of the time value of money which brings into sharp focus the significance of an early start in our life cycle and the negative impact of inflation which reduces the value of money over time. This reduction in the value of money due to inflation should serve as a reminder for us to distinguish between the monetary value of a given dollar amount and its purchasing power.
Finally, the simplified examples presented do not take into account the income that may be earned and the additional savings generated during the working life of any of the individuals under consideration. These resulting savings and investments will certainly modify the ultimate outcomes. In the real world, the rate of return on investment and the annual rate of inflation are rarely constant features. The model also assumes that the each individual will continue with the investment regardless of their personal situation. However, the significance of the key variables identified in the examples cited will still be relevant.