There are three actions that significantly affect the accrual of supplementary savings for retirement. First is the amount (percent of salary) going into savings. Second is the length of time that money has to compound (earn interest on itself). Third is the rate of return that is earned.
Over a working lifetime, the greater portion of the accumulation in a person’s savings will be interest earned rather than money deposited. The “rule of 72” states that dividing the rate of return into 72 will tell how long it takes for money in the account to double. For example, money earning 6% will double in 12 years. Money earning 9% will double in 8 years.
The first lesson to be observed from this is that savings should be started as early as possible. It is more important to save at a modest rate for a longer period of time than to save at a higher rate for a few years.
The second lesson is to not be overly conservative in savings allocations among the available investment funds. The basis for any investment decision centers on the concepts of risk and return. Typically, higher-potential returns involve higher risk. The level of risk a person is willing to take is a personal matter. There are two types of risk that need to be considered in making allocation choice: (1) risk of loss, and (2) risk of inflation. Losing invested money is a concern for everyone. As a result, money is often invested conservatively to avoid loss. This brings low earnings and places the investor at risk of inflation—not earning enough to offset the effects of inflation now and into retirement.
A better approach is to find a comfortable balance between fixed funds—debt instruments that pay a rate of interest over a set period of time (e.g., money markets, short-term bonds, long-term bonds) and variable funds—stocks that provide ownership in companies. This balance of allocation choices may be driven by decisions based on (1) time horizon (length of time before the money will be accessed), (2) risk of tolerance, and (3) financial objectives. One general rule of thumb is to put one’s age in fixed investments. For example, at age 25, a person would have 25% of their investments in fixed funds and 75% in variable funds. A second rule of thumb is the “tummy” test. This is driven by a person’s risk tolerance. A person’s “tummy” will tell them at what risk level they are comfortable. Investment choices to achieve various financial objectives may be structured as follows: