Are you looking to turn your hard-earned paycheck into a nice nest egg for the future? If you are reading this, you probably are. And if you’re reading this, you probably also know that the stock market is the best way to overcome the impact of inflation. Savings accounts, CDs, and even corporate bonds aren’t up to the job.
The fact is, making good returns from stocks does not require a lot of time, effort or maintenance. You are probably best served by being a truly passive investor and simply leaving things alone for years and years. Here’s a simple recipe for multiplying your investments by a factor of 10, and it doesn’t even require you to start with a big chunk of money.
1. Shop in the vast market every year
There are several ways to skin a proverbial cat, but the easiest way is probably the best way too. This is buying in a broad market index such as the S&P 500 with a tool like the SPDR S&P 500 ETF Trust (NYSEMKT: SPY). This index fund gives you balanced exposure to 500 stocks of the world’s largest companies, allowing you to participate in their long-term growth, which averages 10% per year. Some years are better and others are worse. Over time, however, you can expect an average payout of around 10% per year.
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The key is to do regular investments, even when it makes you feel uncomfortable, and even if it means you need to reduce some of your discretionary spending. As you will see shortly, a seemingly modest investment made consistently can become a surprisingly large sum of money later on. Likewise, failing to make this contribution year after year can dramatically consume your eventual nest egg.
Still too much bother? Keep in mind that most brokerage firms can automate the process of smoothly transferring money from a checking or savings account to your investment account and also automate the actual annual (or monthly) investment in a fund.
2. Reinvest dividends and any capital gains
When you buy a stock or fund, you usually have the option, at the time the trade is placed, to reinvest any dividends that the position pays in excess of the same stock or fund. Choose “yes” when given the option and, if your position is already established, contact your broker or log into your brokerage account and switch to this setting.
Of course, it is tempting to simply accept the payment of dividends in cash. You’ll have access to this spendable money as soon as it arrives, even if your ultimate goal is to use these payments to buy more stock or buy other mutual funds. The fact is, too many investors never manage to do this, missing out on a major growth opportunity by sitting idly on their cash or cash-like holdings.
Here’s an example that might motivate you to take this one-time step: While the average annual return on the S&P 500 has been an impressive 11.4% over the past 10 years, that figure rises to 13.5% if you reinvested all the dividends raised in that period. This is a huge difference over time.
3. Leave him alone for as long as possible
Last but not least (and that’s the hard part), do step # 1. 1 for decades, making sure that step no. 2 applies to all new and old money invested in retirement savings.
If you’ve set up your brokerage accounts and automated investments correctly, the only thing you’ll need to do to successfully complete step # 1. 3 is, well, nothing. Assuming a 10% annual return for the S&P 500, a typical career period should place the value of your portfolio in the order of 10 times your total contributions over that time frame.
Surprised? Not be. The graph below illustrates how an annual investment of $ 5,000 made for 36 consecutive years ($ 180,000 of your contributions) will be worth approximately $ 1.8 million at the end of that time frame.
It is called compounding. In this case, what is greatly compounded is your past earnings, regardless of whether they came from dividends or capital appreciation. That is to say, most of the growth here comes from your earnings, not your annual contributions, so the new earnings over previous earnings. Looking forward, during the final year of this hypothetical 36-year period, the market average gain of 10% would translate into net growth of over $ 163,000, dwarfing last year’s $ 5,000 new cash contribution.
Of course, the earlier you start earning something, the more growth can help you in the future.
Less is more
The formula is not complicated. In fact, investors who are committed to keeping things simple often tend to perform better; the pursuit of yields that beat the market by frequently trading individual stocks (ironically) often leads to lagging market performance. Index funds solve the problem quite well.
Furthermore, it would not be wrong to set up scheduled deposits, investments and re-investments in index funds and then not look back for years and years. This approach bypasses the risk of trying to time the market: automation helps enormously in this regard.
The hardest part, then, is getting started as early as possible and staying committed to your automated plan for as many years as you can. While you have to make some tough spending choices to make it happen, in the long run it is worth the sacrifice.
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James Brumley has no position in any of the titles mentioned. The Motley Fool has no position in any of the titles mentioned. The Motley Fool has a disclosure policy.