You'll find plenty of articles on the internet on how to become a millionaire. Here's one example. Never one to be outdone, I think it's time that we all up our game a bit. Becoming a billionaire isn't that difficult. It also offers some important lessons about investing and building wealth.
Let's assume that at the age of 20 we begin to max out a 401k and an IRA. At today's contribution limits, that would enable us to save $23,500 a year ($18,000 in a 401k and $5,500 in an IRA). Let's also assume we'll invest 100% in stocks, and that over a long time horizon, we'll enjoy a compound annual growth rate of 10%. How long will it take us to become a billionaire?
If you're thinking 223 years, you're way off. Using the future value function in excel and compounding the returns monthly, we reach the princely sum of $1,009,076,276.09 in just . . . 84 years. So max out your retirement accounts beginning at age 20, and when you turn 104 you will be a billionaire. Easy peasy lemon squeezy.
Now before you email me, I understand this example is not exactly practical. But it can teach us a lot. Let's start with inflation.
A billion dollars in the year 2100 won't buy what it can today. In the words of Yogi Berra, "a nickel ain't worth a dime anymore." If we assume an inflation rate of 3%, our billion dollar nest egg 84 years from now is worth "just" $84 million. Still a lot of money, but a far cry from $1 billion.
To be fair, we would also need to adjust how much we saved. Over the next 84 years, the contribution limits of 401k and IRA retirement accounts will go up. Assuming the same 3% increase, we'll be maxing out our 401k accounts in 84 years to the tune of $215,000 a year. My future grandchildren will be looking forward to the company match!
The point is that inflation matters. Over long periods of time, even seemingly low inflation rates eat away at the purchasing power of our assets. This is one reason that "safe" investments (e.g., savings accounts, CDs, short term bonds), can be among the riskiest investments you'll ever own.
A second important lesson is the power of small numbers. Take inflation for example. Instead of assuming a 3% rate over the next 84 years, let's assume a 3.5% rate. While that may not seem like a big difference, it lowers the purchasing power of our investment in today's dollars from $84 million down to $56 million.
The same is true with rates of return. Instead of assuming a 10% return, let's assume a 9% return. In 84 years we will not have amassed $1 billion. Rather, our investment will grow to only $487 million. It's hard to imagine that a 1% difference can cost us over $500 million, but that's the power of compounding.
Let's bring our example back down to earth. Instead of investing for 84 years, let's keep it to a more typical 40 year career. Again maxing out our retirement accounts at a 10% return yields $12.3 million after 40 years. Lower the return to 9% and our nest egg drops to $9.1 million. Think about that the next time an investment advisor or actively managed mutual fund wants to charge "just" one percent in fees.
There's one more thing our race to $1 billion can teach us, and it's the importance of time. Recall that it took us 84 years to reach the magic billion. Imagine if instead we invested for just 83 years. How much would we have accumulated? The number drops by almost $100 million.
And back to our more realistic 40 year example. If we shorten our investment period by just one year, our $12.3 million retirement fund drops to $11.1 million. That one year cost us more than a $1 million.
Compounding works it's magic as our investment horizon expands. The last year is far more valuable than the first, at least in terms of absolute numbers (you can't get to year 40 without starting with year 1).
Here are the key takeaways:
- Start investing today. For compounding to work, you must give it time. Even losing a single year can cost you a lot of money.
- What are billed as "safe" investments may prove to be the riskiest of them all. That's not to say that bonds have no place in a portfolio. But successful long-term investing requires significant exposure to equities.
- Every percent matters. Do not let anybody suggest that a 1% fee is "reasonable" or insignificant. It is neither.