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Why I invest

September 9th, 2006 at 06:55 am

In light of all the investment talk of the past few entries, I have a confession to make.

I used to be scared of investing.

Oh, I "knew" that it was the "smart/right" thing to do with your extra money. And that if you do it "well", your money can "work for you", and theoretically multiply itself into unimaginable proportions.

But I didn't trust it in my *gut*. I didn't feel comfortable or confident. What does it mean for money to "work" for you, anyway? You're the only one who can do *real* work. Earning money from the stock market seemed so... intangible. Abstract. Fake, even.

And I've never been much of a risk taker. I've always preferred to play it safe. When I *have* money, I want to *keep* it, and *know* that it's there in the bank, not in perpetually fluctuating share prices. When it earns, it's not real to me, and when it loses, I feel sick.

Interest from a bank--now that's concrete. That's real. That's dependable. And if I have to sacrifice possibly higher returns, then so be it. After all, I'm a frugal person. I can work hard, and make what I earn be enough. I'm not a spendthrift who can ever spend a million dollars, nor do I need to make that money off the stock market. I just gotta keep chugging and saving.

That was me, all of one month ago.

What made me change my mind? Simply the following train of thought.

Assuming that I start work at age 20, retire at age 65, and die at age 90, I will work for 45 years, and be retired for 25.

That means I'll be retired for 25 / (45 + 25) = 35.7% of my adult life. Thus, I'll need to save 35.7% of my salary if I want to keep cash flow and standard-of-living consistent during my working and retirement years.

That seems a bit high, but okay. I'm capable of saving that. Heck, I'm probably capable of saving more if I put my mind to it.

But hang on a second, what if I plugged in some real numbers? Say I wanted to have $40K/year income during retirement. This isn't an extravagant or unreasonable figure, especially considering inflation. Over 25 years, that adds up to...

...one million dollars.


Yup, it's one million all right. "I'm not a spendthrift who'll ever spend a million," eh? Well, I sure am eating my words now. But at least it's better than eating them at age 65 when I have, um, nothing else to eat.

That realization caused me to set my retirement goal at one million. And actually, that's a conservative goal, because not only am I concerned about inflation, I'm also worried about the increased medical care costs (such as prescription drugs) associated with being elderly. I may not be happy about degrading health as one ages, but I'm not in denial, either. So I'd actually like to have two million in order to feel reasonably secure.

Well, can I reach that goal? Let's see...

I'm making $32K/year. At that rate, $1.44 million will pass through my hands over the course of my entire working career.

That's not enough to put away one million, but I won't be staying at this job forever. My income will surely rise if I become a professor or go into industry. But it'll also decrease if I go to grad school, and remain the same if I do the postdoc grind.

No matter how I played with the numbers, even the most optimistic lifetime earnings projections never hit three million.

And this was assuming NO time off for children (and the costs associated with raising them!), unemployment, medical emergencies, or personal/natural disasters.

Oh, and it's also before taxes and living expenses are taken out. Since those are, you know, totally minor.

I also analyzed the situation from a different perspective.

If $40K/year is 35.7% of my annual income, my annual income must be...


But in that income tax bracket, I'll be losing around 45% of my income to taxes. If I'm saving 35.7% for retirement, that leaves me... 19% of my income to actually live on.

That's slightly over $20,000 per year. That's actually how much I've got now, after taxes. Buy a house on this income? I'm dreaming. EEK!

That's when it truly hit me. I *can't* save enough to properly fund retirement. It's just not feasible. If I make $2.5 million during my lifetime and take out $1 million for 25 years of retirement, I'll have $1.5 million left for 45 years of PRE-retirement. Or I'm going to have to somehow raise my annual income to something much higher than $112K/year, and do it, well, NOW.

It's just not going to work.

I *need* to invest. Without those returns, I won't make it. It's as simple as that. I know you can also use real estate, but that's a form of investment, as well--one that takes more capital than I'll have in a very long while.

So... that's why I am investing. It's risky in the same way driving motor vehicles is risky--yes, you can crash, but the vast majority of the time, you'll get where you're going. And if you do crash, chances are, you will recover and not die, especially if you've buckled up (diversified).

How far I've come in just one month. Now if only I can convince my mother that I haven't gone bat sh*t insane... She harbors my old view on investing, and she's horrified by what I'm thinking/doing. Oy.

6 Responses to “Why I invest”

  1. LuxLiving Says:

    Mimi - you are one smart young cookie!! Go Girl Go!!

  2. yummy64 Says:

    You are doing something very smart. Yeah the banks are nice and safe with the interest they pay but look at their profits - they're the ones making the money not the people who invest money in their savings accounts or their CD's.

    My golden rules for infvesting are threefold - Never invest in something you don't understand. If it sounds too good to be true it is. And if you can't sleep at night for worrying about it its not worth it.

  3. amberfocus Says:

    LuxLiving: Aww, you give me too much credit! All I did was make the decision to throw "fuzzy math" out the window, stop relying on my emotions to influence financial decisions, bust out a calculator to get some solid numbers, and draw some very obvious conclusions. Not exactly rocket science. Smile
    yummy64: Yup, bank interest rates barely keep up with inflation. They're good for short-term money storage, but that's about it.

    Your golden rules are great, thanks for sharing! I'm trying to decrease my level of ignorance regarding investing as we speak. I finally know what small-cap, mid-cap, and large-cap funds are, as well as growth, value, and blend funds. Rudimentary, yes. But it's progress!

    I still feel compounding interest is a little too good to be true, but I need to get over that.

    I'm not losing sleep over this, but I *am* starting to dream about it. I wonder if this is a good sign. Blink

  4. Dido Says:

    Glad the calculations got you off the pot, so to speak. You're doing the best possible thing for yourself, and by investing in a Vanguard Target Retirement fund, you are doing it in a very reasonable way.

    Your calculations are a good start but you could still incorporate the time value of money (TVM) into it. For example, using the FV=PV(1+k)^n equation, you find that your desired annual income of $40,000/year will be the equivalent of $233,647/year in 45 years when you retire if inflation is 4%/year (a reasonable, slightly conservative estimate--most estimates are 3-4% over the long haul). Or to turn it around, at 4%/year, $40,000 in 45 years will be the equivalent of $6847 today. You're frugal, but can you really live on that?!

    There's lots of kinds of risk, only one of which is the risk of losing your principal. As these TVM calculations indicate, inflation, while hardly noticable at the day-to-day level, has a major impact over time--hence, inflation risk. The stock market is widely viewed as the best protection against this form of risk.

  5. amberfocus Says:

    Well, savings accounts also have interest, and with ING's 4.40% rate, $40,000 will be worth $277,704.19 in 45 years, which does keep up with an inflation rate of 4%. So the situation isn't *quite* so dire.

    I'll add inflation rates to the List Of Stuff I Must Research On. That list is getting longer by the day! Smile

  6. baselle Says:

    Remember that compounding (where saved money begats money which begats more money) will make your computations a little less dire. And if you shelter your money in a Roth, your tax rate will be far lower, and that will make your calculations less dire, too.

    But the point is well taken: buy stuff that makes money. Instead of buying a case of Coke, buy a share of KO. Smile
    Also, some investing is less risky, even in the same asset class. Risk is a gradient. Investing in the Dow stocks - many of whom pay dividends (paying you to hold their shares even the price doesn't change much) - is one thing, buying penny stocks from a whispered stock tip is another. Holding Government bonds is one thing, holding GM corporate bonds in another. Smile Managing your investments is the same as managing your risk.

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