Investing

Originally Posted by Peter

Actually, your calculations are too simplified, since you don't take into account the ACTUAL value of those admittedly huge amounts of money. You als have to take inflation and the market rates. Say that you take a current market rate 5% into your calculation (which is, given the current circumstances a rather generous guess), lets see what the actual value of your savings will be using annuity calculus*.

If you invest for 20 years :

4000 x a20┐0,05 = 49,848 USD

If you invest for 34 years :

4000 x a34┐0,05 = 64,771 USD

So my rough estimate wasn't so far off it seems...

*The more exact formula being A x [1-(1/1+i)³]/i
With A being the amount of money you put aside, i being the rate, and the 3 representing the number of years.

You are saying saving 4,000 per year, for 20 years, at 5% compounded annually, is going to get you $49,848 in total? Does not compute. Even without interest, you will be getting $4,000 x 20 = $80,000.

And in 34 years, $136,000. Your computations are too low, unless you take that figure to mean the total interest earned (which isn't the case at any rate).

The Annuity Table as follows, assuming you set aside the $4,000 AT THE BEGINNING of every period.

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I'm not saying that the final value of your capital will only be 50 grand, but that the actual value will be worth 50 grand. Money loses value over time, that's why people demand interest in the first place. Interest has two functions; compensate for missed opportunities (if you would have invested the money in something else), and compensation for the loss of value over time. A euro/dollar you have today will be worth less tomorrow, and even less in 34 years. If I could buy a loaf of bread for 75 eurocents 10 years ago, I have to pay almost 2 euros today. This is mainly caused by inflation, and various other factors like devaluations, the economic climate etc.

The 5% that I used is also just an example to simplify things, obviously you'd want to choose an interest rate on your account that is bigger than the market rate and the inflation, to make a bit of an economic profit on your investment. The formulas I used are taken directly from one of my textbooks btw, where we treated a case that is comparable to this, to illustrate the effect of time on monetary value taking compound interest rates into account.

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Oh, you're talking present value, aren't you, assuming inflation is the same as the market rate?

Yes, the value of $357,281.23 in 34 years, compounded 5% annually, is $68,010.20 in today's dollars. In 20 years, it is $52,341.28 in today's dollars, for a difference of 15,668.92. But, you're not investing that many increments of $4,000 in today's dollars - it's spread out through the entire time period.

It is misleading to say, "Oh look, I should just start saving after 14 years instead of now, since the overall difference is just $15,668.92. It's not - the difference is greater - $218,404.22, through the magic of compounding. This is actually worth $41,574.29 in today's dollars. If you choose not to save that $4,000 until you turn 35, well, good luck to you Peter.

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Sorry, we use "Actual" in Dutch, so I'm not too familiar with the correct English terms. We've always been thought to look at the actual value of your investment (according to my textbook, the annuity formula also considers that the amounts of money in the future will not be the same at present value, so they say that the numbers would be pretty accurate given a stable inflation), and it was used in several case studies to show that compound interest can look too alluring when too simplified. Assuming inflation = market rate is the standard method that we use, since the actual calculations will be too complex, and not very trustworthy since there are so many factors that you can't take into account.

In a different turn, why is there a need to start saving on your own at 21? Don't you have state pensions and retirement funds at your job (the 401k thing I assume)? My parents, while still years away from retiring could easily afford to quit their jobs now, and keep their current living standard with the state pension and the money they saved through their employer, without even touching their personal retirement funds for at least 10 years (and this is taken into account a lot of hardship, since both of my parents have a chronic illness, but since we have public health care, it isn't as important as it is in the US), but I'm guessing it's not that easy in the US.

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Originally Posted by Peter

In a different turn, why is there a need to start saving on your own at 21? Don't you have state pensions and retirement funds at your job (the 401k thing I assume)? My parents, while still years away from retiring could easily afford to quit their jobs now, and keep their current living standard with the state pension and the money they saved through their employer, without even touching their personal retirement funds for at least 10 years (and this is taken into account a lot of hardship, since both of my parents have a chronic illness, but since we have public health care, it isn't as important as it is in the US), but I'm guessing it's not that easy in the US.

Part of the problem is that a lot of young people don't expect Social Security to be there for them in their old age since there have been so many dire reports saying something to the effect that the system will go bankrupt long before then. US companies have also been phasing out pension plans, so that's no longer going to be a sure bet.

401(k) plans work in that they shift the burden of managing retirement accounts from the employer to the employee. How this works is that a certain amount of money is withheld from the employee's paycheck each pay period (an amount that is deductible for tax purposes) and the employer matches a portion of the amount withheld. The amount put in then grows tax-free until retirement, where the employee is taxed on the amount that they withdraw. Under this system, the employee has a lot of control over how the money is invested and which funds to invest in. However, that means that the employee needs to be responsible to check their investments and make sure their asset allocations fit in with their retirement goals.

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