Alex Garcia’s recent article on how to make a million nailed a crucial point most investors fail to recognize. Put simply: Most investors fail to understand that it is easy to create wealth if you have a rigorous savings and investment plan in place.
This is something I’ve looked at several times before. On my blog, a few months ago, I highlighted a study from David Bach’s book, "Smart Couples Finish Rich." Even though the book is now nearly 15 years old, its wisdom is timeless, as the principles remain the same.
In the pages of the book, Bach shows the different rates of saving required to build a fortune of $1 million by the age of 65 at various age groups.
The one caveat of this particular study is that it assumes savers can achieve an annual return on savings of 12%, which is unlikely today. That being said, with the average annual total return of the S&P 500 over the past 100 years coming in at around 10% per annum, this rate of return is not wholly achievable.
On the way to a million
According to Bach’s calculations, to hit $1 million before 65, you only need to save as little as $61 a month or $730 a year if you start at age 20. Even for those on the lowest wages, this is not an unachievable sum.
The numbers also extend to show how much you need to save if you put saving off until the end of your career. Bach’s figures show that if you start saving at age 40, you would need to set aside $625 a month or $7,500 year to reach $1 million by age 65 — that’s ten times more to put away every month than if you started saving two decades earlier.
The key takeaway from all of this is that if you want to save lots of money, you need to start saving early. However, the figures fail to take into account one major factor: risk.
Pay attention to risk
When I say risk, I’m not talking about market volatility. I mean two specific kinds of risks 1) total loss of capital and 2) the risk that you’ll make a mistake.
It’s easy to avoid the first risk. The best way to achieve the best return on your money with the least effort is to invest in an S&P 500 index fund. This is an approach even Warren Buffett (Trades, Portfolio) (the most celebrated stock picker of all time) advocates.
The second risk is much harder to eliminate. The psychological risk of investing cannot be seen, but they are likely to be much more damaging to your wealth over time than bad investments. Saving and investing for the long-term only works if you use a long-term horizon. If you give up after 10 years, you won’t see the results you want. Moreover, if you sell out of the index fund, and invest in a stock you think might have better prospects, there’s a significant risk that you might end up underperforming or even losing money. This is entirely avoidable if you just keep your eyes on the prize.
How to make sure you don't trip up
How do you avoid making these mistakes?
The best defense is often offense, and that’s the best way to understand what can hold you back -- making a concerted effort to understand psychological biases, what they are and how they impact your trading decisions is key if you want to avoid stumbling over them.
Also, a plan will help you stick to your goals, something Seth Klarman (Trades, Portfolio), one of the best value investors of all time has made clear.
“Controlling your process is absolutely crucial to long-term investment success in any market environment.” A focus on process, not outcome, will help you make the right decisions in a falling market and not become a slave to your emotions, which may lead you to make mistakes.
Disclousre: The author owns no stock mentioned.
