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How to keep time on your side

May 21, 2013

Time is on your side, though it might not always seem that way.

Many investors underestimate the value of time. Combining a disciplined investment program with the passage of time can add considerable horsepower to your portfolio through what's known as compounding—that is, the gradual accumulation of earnings that happens when you reinvest your gains rather than cashing out.

With a little financial common sense and a measure of self-discipline, you might be able to build up your savings a lot faster than you'd think. That's why it's never too late (and certainly never too early) to start saving and investing.

The power of compounding

When you reinvest your investment earnings instead of cashing out, you give them a chance to grow. With each passing day, your initial gains can produce gains of their own, and so on, often producing dramatic results over long periods. That's compounding in a nutshell.

Let's say you start by investing $10,000 and go on to earn an average annual return of 6%. If you faithfully reinvest that 6% each year, your account could grow by almost $50,000 over 30 years, even if you never invest another cent. And as you can see here, adding ten more years could more than double your earnings.

How reinvesting can pay off over time

This hypothetical example assumes two initial $10,000 investments, with each earning 6% annually. The lower line shows that the investment value remains constant when earnings are taken as cash each year. The upper line shows the value when the same earnings are reinvested annually. As the reinvested earnings generate their own annual returns at 6%, the accumulated value accelerates toward the end of the 40-year period. Taxes are not included in the calculations. This graph does not represent the returns on any particular investments.

Setting the right pace

Understanding your time frame—that is, how soon you'll need to access your money—makes it much easier to allocate your assets among stocks, bonds, and cash. In some ways, it comes down to choosing whether to save or to invest. In other words, it's a question of whether to preserve your assets or attempt to grow them by taking a certain amount of risk.

  • Short-range goals. When you're saving for something that's just around the corner, your main objective is to preserve the value of your principal. Historically, money market funds, CDs, and bank savings accounts have provided the greatest stability—offering relatively little principal risk, but less long-term growth potential than bonds or stocks.
  • Medium-range goals. For something that's a little farther out, you might consider supplementing your cash savings with investments in short-term bonds and perhaps a modest allocation to stocks. Bonds have offered more growth potential than cash—but more risk, too.
  • Long-range goals. If your objective is many years off, stocks historically have offered the greatest long-term growth potential, but with the highest overall risk of the three main asset classes. You can offset some of this risk by mixing some bonds (and possibly cash) into your portfolio.

Time to take control

It's almost never too late to begin setting money aside for retirement, college, or any other goal. Granted, it's much better to start early. But if you're behind schedule, your best chance of catching up is to save as much as you can, starting immediately, and then let compounding go to work for you.

There are several ways to make up a shortfall. For your retirement savings, for example, you can take advantage of "catch-up" contribution limits to your IRA or employer-sponsored savings plan if you're age 50 or over. You might also think about working a few extra years.

And remember that the clock doesn't stop ticking once you've retired. With people living longer, healthier lives, retirement is becoming a 20- or 30-year proposition. That means there may still be a place for growth-oriented long-term investments in your portfolio.


NOTES:

  • All investments are subject to risk.
  • Investments in bond funds are subject to interest rate, credit, and inflation risk.
  • An investment in a money market fund is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Although a money market fund seeks to preserve the value of your investment at $1 per share, it is possible to lose money by investing in such a fund.
  • Past performance is no guarantee of future results.
  • When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
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