Today’s guest post is by @FinEngr, fellow Yakezie member and author of Engineer Your Finances. He applies a background in engineering to personal finance. FinEngr gives readers a different perspective on money with the belief that everyone has the ability to reach their financial goals through education and continual refinement.
If you’ve been keeping up with Sweating the Big Stuff, you’ll know Daniel’s been hard at work funding his Roth IRA. He’s done a great job of adjusting his lifestyle to accommodate his aggressive investing goals, which leads in nicely to the topic at hand.
Most people understand the concept of compound interest and the benefits of starting sooner rather than later, but did you know you can squeeze EVEN MORE out of your investments by starting EVEN EARLIER?
That doesn’t make sense? How can someone so young start any earlier?
Plenty of friends ring in the New Year by starting on their resolutions or recovering from hangovers, but my big excitement is fully-funding my Roth IRA. While this may seem a bit much, it’s a preplanned event much like what was discussed in the defense is a calculated defense.
I recently had this conversation with a financial adviser whom I respect, partially because he’s an ex-engineer, but primarily because he doesn’t mind taking time out of his day to help young investors. I’m not even under his employer’s plan anymore, and we still trade emails now and then. Too bad there aren’t more like this in the industry.
He agreed, noting that it should give your contributions a (generalized) 4% bump over time. That’s pretty considerable. Especially since it involves no special investment knowledge.
Of course, it makes perfect sense applying the principles of compounding. Consider investments paying monthly or quarterly dividends. If you’re reinvesting those dividends, then the shares received are calculated based on the shares already owned. The earlier you have that money invested, the more shares you’ll receive. And the cycle continues each month, quarter, or year.
Although you’re not spreading your investments throughout the year, single years seem almost negligible when you’re considering decades, or half-centuries in Daniel’s case, of investing. There are plenty of (decent) articles out there refuting the idea. Actually, Warren Buffett has even been known to remark on the pitfalls of dollar-cost averaging.
There’s no set strategy either. Maybe it’s too nerve-wracking or simply unfeasible to get everything in all at once. Instead, maybe you shoot to get everything in before the first declaration date or semi-annual dividend.
Just to illustrate the benefits of front-loading, I went over to Dinkytown and plugged in some different scenarios into their Future Value Calculator. To prove the point, the only variable I changed was whether there were periodic deposits or a single lump sum.
I’m not sure why, but I spend the time making these different graphs and then scrap them anyway. At any rate, here are the parameters used:
Case A = $5,000 initial deposit
Case B = $416.67 monthly deposit ($5,000 yearly deposit / 12 months)
Scenario 1 = Compounded Monthly, 1.25% Yield, 1 Year
Scenario 2 = Compounded Quarterly, 3.5% Yield, 5 Years
Scenario 3 = Compounded Annually, 7% Yield, 10 Years
Drum-roll please… And the FV results were:
Scenario 1, Case A = $5,063
Scenario 1, Case B = $5,034
Difference of $29
Scenario 2, Case A = $33,741
Scenario 2, Case B = $27,357
Difference of $6,383
Scenario 3, Case A = $83,754
Scenario 3, Case B = $71,675
Difference of $12,079
These were my own concoctions so I urge anyone to go over and plug in their own numbers. What you will find is that any value, over time, should return more through front-loading than periodic deposits. Now, I believe that the adviser noted (generalized) because you need to factor in the positive AND NEGATIVE fluctuations of investments.
If the better return isn’t enough to entice you, let me offer a few other benefits in closing.
Being One-Year Ahead
Like I mentioned, the contribution is a planned event. The year prior is spent saving for that January deposit. As a side effect, holding yourself to this standard will help develop more savings discipline.
Checking anything off your financial to-do list allows you to explore other investments. Or spend more time with friends and family. Or whatever else it is that you enjoy. Point is, It’s just one little thing off your back that you won’t have to worry about.
Alright readers, now it’s your turn. What do you think of the idea? A worthwhile effort or too many holes in my assumptions? Do you think that training for this goal, whether it be your IRAs or 401ks, will better prepare you for other saving goals?