Perhaps the best way to build your net worth is to start early. The chart in Figure 3 illustrates the power of compounding by showing what happens if you were to start with one penny and double your savings every day for four weeks. As you can see in the chart, at the end of week one you would have saved a paltry $0.64. At the end of week two you would have saved $81.92. Things aren't looking good. Or are they? By the end of week three, you would have been up to more than $10,000 and by the end of the four-week period, you would have been a millionaire!
Figure 3 The power, or magic, of compounding.
This illustrates the amount of money you would end up with if you started with one penny on day one and doubled your money each day for four weeks. At the end of the fourth week, you would be a millionaire! (of course, you would have to come up with $671,088 on the last day, so this isn't really practical).
Is this realistic? Not really, since during the last week we would have to come up with hundreds of thousands of dollars each day to meet our daily doubling goal. But this does serve as an example of what can happen when you give your money the biggest advantage you can: time. Starting early is the best way to build your wealth and save for retirement.
The magic of compounding allows you to generate wealth over time and requires only two things: the reinvestment of earnings and time. If you make a single $10,000 investment when you are 20 years old, for example, it would grow to over $70,000 by the time you were 60 (based on a 5% interest rate). That same $10,000 investment made at age 30 would only yield about $43,000 by age 60 and made at age 40 would yield just $26,000. The longer money is put to work, the more wealth it can generate in the future.
When it comes to debt, the best defense is a good offense. Avoiding debt is one of the most important steps you can take when trying to improve your financial situation. Consider a mortgage. It is a monthly expense that continues to exist (on average) for 360 months (30 years). While today's lenders might have a more difficult time talking you into more house than you can afford, it is still very easy to end up in a property that is more than you need, both in terms of price and features. Imagine if your mortgage payment was $100 less each month, and you put the money you saved into an investment and allowed it to grow. Over the 30 years, you would have contributed $36,000 towards this investment ($100 each month X 30 years), but if you earned 5% on the investment, it would be worth $83,572.64 at the end of 30 years. Imagine if you took a mortgage that was $200 less per month.
Recurring monthly expenses also nibble away at potential savings. Often times, you can reduce these monthly charges by calling customer service and asking for a better rate: they are not going to let you know about any promotional rates unless you ask. It many cases, it is worth the ten minutes that it takes to call and negotiate a better rate. If they tell you the rate is good for one year, make a note on your calendar to call back in one year to negotiate a better rate – again.
Insurance premiums are another area where you can reduce spending. Sometimes the savings are substantial just for updating your information – you could receive a discount, for example, by letting your home insurance carrier know you have dead-bolt locks and smoke detectors. You might also be able to reduce your car insurance by letting them know if don't commute to work (or if your commute is shorter than it used to be). For both home and automobile insurance, you may be able to reduce your premiums by using the same insurer for both policies (many offer a 5% - 15% discount for combining policies) or by raising your deductibles. Take note, however, that a higher deductible doesn't always make sense. For example, raising your automobile deductible from $250 to $500 might not make sense if it only saves you $5 each year.
The bottom line here is this: the less you spend, the less debt you will have. Controlling debt on the front end – instead of figuring out how to pay down debt once it has accumulated– is a lot easier in the long run.
A well-diversified portfolio of dividend-earning stocks, bonds, mutual funds, annuities and retirement savings plans can help you increase your net worth and provide a valuable income stream during retirement. For example, assume you purchase 1,000 shares of stock ABC at $100 per share, or for a total investment of $100,000. If the stock has a 4% dividend yield, you would have received $4 per share, or a total of $4,000 in dividends. If the company increases its dividend by 7% each year, you would be earning close to $12,000 each year in dividends after 10 years (if you reinvest dividends), or more than $60,000 each year after 20 years.
While it's never too late to start saving for your nest egg, the sooner the better because time allows the money to grow. In general, younger people can take on higher-risk investments because they have more time to recover from losses. As we age, it is generally recommended that we move away from the riskier investments and into those with lower risk. Unfortunately, these lower risk investments come with lower potential rewards.
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