Monday, April 25, 2016

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Building Wealth Takes Time - Why to Teach Teens to Start Saving Young

"It is crucial to understand that wealth flows from savings, not from income."
- David Chilton, The Wealthy Barber Returns
What if the greatest financial gift you ever gave a child didn't cost you a cent... but meant that they ended up with a nest egg of a million - or two - dollars?
If you're the frugal sort, that should put a smile on your face.
So what IS this great financial gift?

Why, advice, of course. Which is: if one starts to save regularly as a young person, then the amount of money that can be accumulated over a significant period of time is staggering.
For it's not the amount of money a person earns that determines whether or not they will be wealthy; it is the amount of money the person sets aside that really matters. And the sooner they get started, the better.
A few weeks ago, I read an excellent article in the Globe & Mail about the importance of teaching kids about how - and why - to start saving when they are young.
"Financial freedom occurs when a person's investment income is greater than their monthly expenses. Many people who appear wealthy simply have high incomes but little or no net worth; they may also be in huge debt and not even close to financially free."
- Nancy Phillips, author of The Teen Steps to Success Guide, as quoted in the Globe & Mail article, "Parents of millennials, teach your children well," by Gail Johnson, Jan 16, 2016
"Financial experts agree that teaching children about money early is vital, as early as 5 or 6, or at least well before they start using credit cards and apps," said Johnson.
"Research has shown our belief system around money is set by age 7," explained Phillips, "mostly from modeling the behaviour of those who raise us."
Wow.
To illustrate the importance of starting young to save, here is an example by Nancy Phillips in her book, Steps to Success Teen Guide: 25 Financial and Life Success Lessons to Help You Achieve Your Dreams:
"Say you start investing $2000 a year at 19, then stop at 29 (so a total of 10 years) for a total investment of $22,000, while your brother starts putting aside $2000 a year at age 38 until he's 60 (so 22 years for a total investment of $46,000). Assuming an annual return of 6.5%, you'll have more than $231,000 in your portfolio by age 60, while your brother will have about $107,000."
In other words, time is what is needed for compound interest to work its magic.
And money, of course. But surprisingly - and this is the beautiful part - not necessarily a lot of it. In fact, what is far more important than the amount of money saved is developing the habit of regularly setting aside money i.e. paying yourself first.
I've yet to read a financial book (and I've read an awful lot of them) that doesn't drive this crucial point home to the reader.
Pay yourself first - and you will become wealthy.
As for how much to pay yourself?
"Wealth beyond your wildest dreams is possible if you learn the gold secret: invest 10% of all you make for long-term growth."
- David Chilton, The Wealthy Barber
Here are some further figures to ponder (from The Wealthy Barber):
"If you invest $2400 a year, say $200 a month, for the next 30 years and averaged a 15% return a year, how much money do you think you'd end up with?"
$1.4 million.
Wow!
But, for all the young 'uns out there, get this: "If you put just $30 a month away at age 18 and you continue until you are 65 (so 47 years), averaging 15% annual return, how much would you end up with?"
$2 million.
WOW!
But if you're a Canadian, there's even better news!
TFSA Contributions in Canada
Now, if you live in Canada, the annual TFSA contribution limit is $5500.
So if a 20-year-old invested $5500 in a TFSA that earns an average of 7% interest per year (compounded quarterly) and contributed the max of $5500 each year (and don't draw any money out) for 40 years, by the time the person is 60, how much money would they have accumulated?
$1.3 million! AND NO TAX WILL BE PAID ON THAT MONEY!!
So why don't more people - young or not-so-young - save on a regular basis?
"One of the biggest reasons that it's so difficult to save is that no one out there really wants you to. It's true. Almost everyone want you to spend as much as possible."
- David Chilton, The Wealthy Barber Returns
Sadly, it IS true. But I wonder if it is also the WAY we try to communicate the savings message to young people that could use some improvement? I mean, when I was 16, I pretty much tuned out whenever I heard the words, "saving," "retirement," "compound interest" and "tax."
Blah, blah, blah... bo-ring.
So the other day, I happened to be with a friend's daughter on her 16th birthday and the subject of personal finance happened to come up.
Now, as perhaps you may have noticed, teens DO tend to like the words "money," "cash," and "rich," so I tried to make sure those words made an appearance... at least in the first part of the conversation.
And before I knew it, I was googling a compound interest calculator on my phone and punching in numbers - at the birthday girl's request!
"So let's say I put aside $100 a month, starting now," she said. "How much would that be worth in 50 years, when I'm 66?"
I began punching in the numbers. "I'm going to put in an average annual return of 7%, compounded monthly... "
She shrugged and resumed looking at her phone.
"The amount," I said, a moment later, "would be $551,263.17."
She nodded, somewhat impressed.
"But," I continued, "if we raise that rate of return to 9%, compounded monthly, which is achievable over a 50-year span, let's see what you get... "
A minute later, I had the answer: "$1,184,513.84."
The birthday girl looked significantly more impressed. She even looked up from her phone!
Then her eyes narrowed a little and she said, "Since I will be making a LOT of money someday, I'll be able to save more than $100 a month. So what if I increase the monthly amount?"
Unable to contain my excitement (that a teenager was actually interested in a personal finance discussion... on her birthday yet!), I made a quick change in the criteria on the compound interest calculator.
"Let's say you increase your monthly payments by just 5% each year," I said. "So this year, you contribute $100 per month. Then next year, you contribute $105 per month. Then the year after that, you contribute $110.25 per month, and so on, so very do-able... "
I saw the new total, smiled, and looked up from my phone.
"What?" she said.
I read her the amount: "$2,225,421.89."
The birthday girl and her sisters - a 14-year old and a 7-year old - also in the room, all looked at me... rather impressed.
You just never know where the seed of an idea will take root... and grow into a multi-million dollar tree.

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