It can be stressful to think about saving and investing for the future, especially as students. Student debt, credit card balances and an overall high cost of living in today’s big cities can make any savings goal seem like a distant mirage. However, it is easy to underestimate just how important it is to start your saving and investing plans as early as possible.
There is no secret to building wealth over the long run. It comes down to a few simple yet consistent tasks, as well as some favourable results from the financial market. Although we cannot control how the market performs in any given year, we can control the steps we choose to take.
Here are the three essential steps to build your wealth:
Spend less than you earn
Despite seeming simple, spending less than you earn is arguably the biggest hurdle facing most students coming out of school. Today’s recent graduates are burdened with paying high rates of rent and repaying student loans on an entry-level salary. After these mandatory expenses, it doesn’t take many taps of the credit card to eliminate any leftover savings from a recent graduate’s budget.
However, our budget is something that we can control. There are apps that can help you track your spending, such as Mint, which will show you where the bulk of your paycheck is going.
The next step is to compare your weekly, monthly and annual expenses to your income. You should be earning more than your expenses, which allows you to save the difference. Most saving and investing goals fall off the rails at this point.
Turning saving into investing
The next step is to start investing your savings in a diversified portfolio that matches your risk tolerance—your ability and willingness to withstand swings in the value of your investment. You should always consult a professional investment advisor prior to making any investment decisions. They will be able to help you build an appropriate portfolio.
Fortunately, there are many resources available that can make this process easier. Companies like Wealthsimple can help you build an appropriate portfolio for your risk profile, while also reducing the fees you pay. This is great for those who are just beginning their investment career.
We cannot talk about investing without mentioning investment horizons and compounding. Your investment horizon is simply how long you plan on holding your portfolio of assets. Compounding, on the other hand, is the idea of earning investment returns on top of previous returns. The longer your investment horizon, the greater the benefits will be from compounding.
The importance of compounding
Let’s say you invested $100 and earned 10 per cent in the first year. At the end of the year, you would have your original $100 plus the $10 return that you received. Then, imagine that you continued to invest the $110 and earned an additional 10 per cent return in the second year. This 10 per cent return would now earn you $11 and leave you with $121 in total at the end of the year.
These may seem like small incremental gains, but the value of compounding returns over a lifetime can be astounding. To demonstrate the long-term impact of compounding and the importance of investing as early as possible, let’s use another example.
Let’s say that John and Chris are both recent graduates at the beginning of their careers. They both have the same income and both plan to retire in 40 years. John wants to get a head start on compounding, but he knows that his entry-level salary makes it difficult to save. However, after reworking his budget, he manages to save and invest $2,000 per year for the first 10 years of his career.
Chris, on the other hand, comes to the conclusion that he doesn’t make enough income to merit a savings plan. He decides to put off savings and investments until he has a higher income. After ten years, both John and Chris are earning higher salaries and they both decide to increase their annual savings to $10,000 for the remaining 30 years of their careers.
Let’s assume that both of them can earn a compounded annual return of seven per cent on their investments over their entire 40-year long careers. By the time they retire, the value of John’s portfolio is $1,154,957 and the value of Chris’ portfolio is $944,608. Chris still has an impressive portfolio, since he has managed to compound returns for 30 years. However, what’s surprising is that the $2,000 per year that John saved and invested in the early years of his career resulted in a $210,349 difference at retirement.
This is a simplified example, but it shows that saving small amounts of money during the early years of your career can have a significant impact in the long run.
The next time you go to tap your credit card, think about the compounded value of your money—it may make some purchases seem less important.
Thus, in order to build wealth over time, make room in your budget for savings, start investing early on, and utilize compounding.
