Jan. 11, 2023
The beginning of the new year is an ideal time to update your financial plans and, if you are in a position to do so, contribute to your investments. For young people in particular, maximizing the time that your capital has to compound will make a significant difference to your wealth over time.
When investing, most people focus on the return that they earn while failing to realise the importance of a long, uninterrupted investment runway. The story goes that, when asked why he had not spent the money he had been given to get a haircut, a teenage Warren Buffett replied, “Why would I want a $300,000 haircut?” Even at a young age, Buffett understood that if, in addition to the return on your initial investment, you earn returns on your returns, the growth in your capital becomes exponential over the long run.
Here are some basic investment guidelines to assist you in maximizing your long-term wealth and your financial optionality along the way. All of them are simple, but not easy.
Start saving early and save regularly
Saving often seems difficult, particularly for young people. Starting with small, regular amounts can make it easier to begin and for it to become habitual. It might help to set aside part of your monthly salary or annual bonus. It might also help to have the savings bypass your chequing account and go directly into your investment account – the funds will not be ‘seen’ and there will be no temptation to spend them.
The sooner you start saving, the greater the power of compounding. If you invest $1,000 at age 25 and earn 9% a year for 40 years, by the time you turn 65 it will be worth more than $31,000. In contrast, the same amount earning the same return, but invested at age 35 for 30 years will be worth only about $13,000.
In addition, adding to your savings on a regular basis is powerful. Using the example above, if you invest $1,000 each year from age 25 for 40 years, the $40,000 invested will grow to almost $370,000.
Invest to match your goals and time horizon
Everyone’s investment approach should suit their personal situation and the purpose of the capital that they are investing.
If your long-term goal is to build a capital base capable of providing future cashflow and a security net, your objective should be to grow it safely at a rate that is above inflation on an after-fee and after-tax basis. Buying pieces of high-quality companies that will be around and worth more in the years to come (i.e. stocks) is a proven way to do this.
In any given year, stock market returns are random and markets regularly have down years – most recently in 2022 and 2018. However, stock market returns are relatively predictable over the long run (10 years or more). In the United States, the stock market has produced attractive annualized long-term total returns of about 10% before fees for more than a century.
Not investing appropriately, including being overly conservative by investing too much in bonds or fixed income securities, is risky, particularly for someone with a long investment horizon. A young person investing along the lines above will earn three times more from age 25 to 65 than if they decide to ‘play it safe’ and invest in a way that earns an annualized return of 5%.
Maximize your time in the market, don’t try to time the market
One thing that has not changed in the past century is that most investors tend to buy stocks when they are going up and sell them when they are going down.
Studies show that, because of buying and selling at the wrong times, investors in, for example, index funds consistently underperform the index the funds are tracking by a much wider margin than the fees they are paying.
The reason for this is because the short-term volatility of the stock market makes people emotional – both greedy and fearful. Many investors also like to believe that, when the market begins to fall, they can get out and then be smart and brave enough to reinvest when it has bottomed. Unfortunately, they only see the bottom after it has passed. No matter what anyone says and how many forecasts are made, stock markets are not predictable in the short-term. Also, the best periods in the market often follow the worst periods and have a disproportionate impact on your overall long-term return.
The solution? Only invest as much money in stocks as allows you to sleep at night and keep that capital invested through thick and thin.
Take advantage of your tax-sheltered accounts
Tax-sheltered accounts such as RRSPs and TFSAs allow capital invested inside of them to compound tax-free. They provide an investment advantage that should be utilized to the maximum extent possible.
If you are earning a good salary and in a relatively high tax bracket, contributing to your RRSP first will probably make the most sense, as the tax credit received will reduce income tax owed. If you are fortunate and have surplus savings after having fully contributed to your RRSP, then you should also contribute to your TFSA.
Today, the maximum annual contribution to a TFSA is $6,500 – often not large enough for people to focus on doing it every year and early in the year, without realizing the long-term consequences.
However, making $6,500 annual contributions starting at age 18 (the earliest year for contributing) until age 65, and assuming an investment return of 9%, the total contributions of just over $300,000 will grow to about $4.4 million. Think of it like building a pension.
For parents reading this article, helping your child make their TFSA contributions in the early years is an amazing gift. The contributions made from age 18 until 30 (12 years) will be worth more than all of those made from age 30 to 65 (35 years) due to the power of compounding capital over the longest possible period of time.
If you earn enough to save and live a long, healthy life, the ability to achieve financial independence in retirement, and to have financial flexibility along the way, is largely in your hands.
This Globe and Mail article was legally licensed by AdvisorStream.