How to become a millionaire in 50 years or less

a retirement guide for 20-year-olds by Russil Wvong

I had a conversation recently at a party about retirement ("living on Dr. Ballard's") and how much you need to save to be able to retire. I figured if I wrote up the math, it might be useful to people who haven't figured out investing yet.

Disclaimer 1: Some of the details (e.g. RRSPs) are somewhat specific to Canadians.

Disclaimer 2: I'm not a professional financial advisor, and this isn't professional financial advice. If you need more detailed information, I'd suggest reading Andrew Tobias's book The Only Investment Guide You'll Ever Need, and/or consulting a professional financial advisor.

The problem

Suppose you're a 20-year-old Canadian. You don't have much faith that the Canada Pension Plan will still be around by the time you retire; you're worried that in your old age, you'll be trying to survive by eating cat food.

How much do you need to save to be able to support yourself?

The magic of compound interest

Let's start with some totally unrealistic assumptions, to make things simple. Suppose that inflation is 0%, and that you can get GICs at 10%. And as a target, let's say that you want to have at least a million dollars by the time you're 70. That should be more than enough to live on comfortably: that'll give you an income of $100,000 annually.

Suppose you save $1000 this year. You invest it in GICs, at 10%. You keep it invested at 10% for the next 50 years. How much will you have, from this one payment of $1000?

After the first year, you'll have $1000 + $1000 x 10% = $1100. After the second year, you'll have $1100 + $1100 x 10% = $1210. After the third year, $1331. Etcetera.

Instead of repeating this 50 times, we can use an approximation called the Rule of 72. The rule says that if you're getting x percent on your money, then 72 divided by that percent is the number of years that it takes to double.

For example, at 10%, it takes about 72 / 10 years to double, or about 7 years. At 8%, it would take longer, about 9 years. At 12%, only 6 years.

So at 10%, after 7 years, your money has doubled from $1000 to $2000. After 14 years, from $2000 to $4000.

In 50 years, it doubles roughly 7 times (7 x 7 = 49). Which means that your single investment of $1000 has grown to roughly $128,000. Other than the work you did in the first year to save the money, you haven't had to do anything for the next 50 years.

That's roughly one-tenth of your target. If you want to have a million dollars, you'll need to invest ten times that amount: say, $1000 a year for the next 10 years.

That translates to saving roughly $100 a month. Not too bad. If you can put more in, earlier, even better.

What about taxes?

Remember this: your RRSP is your friend. (For American readers: replace "RRSP" with "401(k)".)

The money that you put into your RRSP isn't taxed. More importantly, the money you earn inside your RRSP isn't taxed.

(If you're getting 10% on your money, and it's inside your RRSP, you get to keep the entire 10%. If it's outside your RRSP, and your marginal tax rate is roughly 50%, you only get to keep 5%.)

What about inflation?

Zero inflation is unrealistic. It's more realistic to assume about 2%. Inflation that's higher than that is bad for the economy (as people found out in the 1970s), so the Bank of Canada is strongly motivated to keep inflation under control, using interest rates.

If the average rate of inflation for the next 50 years is 2%, then a dollar 50 years from now will be worth roughly (1 - 0.02)^50 = 36 cents, and so your $1,000,000 will be worth about $360,000 in today's dollars. That's still enough to give you an annual income of $36,000 -- well above the cat-food level.

What about getting 10%?

The nice thing about GICs is that there's very little risk. You know how much money you're going to be getting when they mature. The only risk is that the bank might go bankrupt, which is a pretty small risk if you're dealing with one of the big banks. (GICs with the big banks are also insured by the Canadian government for up to $60,000, which reduces the risk further. Now your only risk is that the Canadian government might collapse. If that ever happens, you'll be too busy trying to survive the resulting anarchy and flee to a refugee camp south of the border to worry about your retirement savings.)

The downside is that with GICs, you can only get 5%. At that rate, it takes 14 years for your money to double, so an investment of $10,000 would only grow to about $115,000 in 50 years. If you managed to save $300 each month instead of $100, you could get up to $300,000 or $400,000, but you should also think about taking on a little more risk than just GICs.

The general rule when it comes to investments is that the return on your money depends on three things: volume (how much you invest), patience (how long you're willing to tie it up for), and risk. Patience is already helping you out a lot here -- you've got 50 years for your money to grow. Volume isn't going to help much. That leaves risk.

One way to manage risk is to think of a pyramid, with lower-risk investments (e.g. GICs) at the bottom, and high-risk investments (e.g. Bre-X) at the top. You want to have most of your money in the lower-risk part of the pyramid, with less and less as you go up the pyramid:

           *         commodity futures, gold, options, speculative shares
          ***        real estate investments
         *****       growth shares, growth mutual funds, invetment mortgages
        *******      balanced mutual funds, blue chip common shares
       *********     corporate bonds, preferred shares, income/bond mutual funds
      ***********    guaranteed investment certificates (GICs)
     *************   government bonds, term deposits, treasury bills
(I've adapted this diagram from an Alberta Consumer and Corporate Affairs booklet that I picked up in the Edmonton public library several years ago, called 2000 A.D.: A Guide to Financial Awareness.)

In particular, over the long term, the stock market has averaged about 9% annual appreciation. As companies do well and their earnings grow, the value of their stock rises; in the short term, there may be much sharper increases (now, for instance) as well as sudden declines (e.g. in the 1970s), but over a 50-year investment period, as far as anyone can tell, the stock market should rise by about an average of 9% annually.

If you're just getting started, you may not be comfortable with the idea of putting your money into the stock market. (I certainly wasn't when I started.) One suggestion would be to start by putting your money into GICs, and as you get more familiar with investments and stocks, to start investing in some of the larger equity mutual funds, e.g. Trimark. There's something called dollar-cost averaging -- basically, investing the same amount of money every month -- that can also help to reduce the risk.

If you get an average of roughly 8% or 9% over the course of the next 50 years, you should do fine. You can compensate for a somewhat lower rate of return by saving more.

(Warning: As of July 1998, the US stock market is looking dangerously overvalued. The Economist has a good article on this, "America's Bubble Economy." You may want to go ahead and invest in the stock market, but if you're just getting started, I'd strongly recommend that you first read the Andrew Tobias book first.)

What if I want to retire before I'm 70?

I don't have any useful advice to offer. There was an interesting article in the June 1995 issue of Saturday Night Magazine, titled "Grandma! Grandpa! Back to Work!" The article argues that the idea that we can all retire at 65 and spend the next 20 years on vacation isn't sustainable. The author points out that when Mackenzie King introduced the first Canadian pensions in 1927, the average life expectancy was 61. Today it's 78.

Besides, I'm not sure it makes sense to plan to grind through life now with the idea that you'll only get to enjoy it when you're 65. A better idea might be to enjoy whatever it is you're doing now.

How am I supposed to save $100 a month?

If the idea of trying to save $100 a month is dismaying to you, Andrew Tobias has some useful suggestions in The Only Investment Guide You'll Ever Need.

If you're a typical North American middle-class consumer, it's also helpful to keep in mind that above a certain level, happiness has very little to do with how much you spend. Advertisers spend huge amounts of money to convince us otherwise, but will driving a more expensive car really make you happier?

Further reading

Andrew Tobias is great: concise, clear, and hilarious. Most of what I know about personal finance I learned from reading his books. The latest edition of The Only Investment Guide You'll Ever Need is pretty good, but you may also want to check out earlier editions at your local public library (some of the jokes were excised in the later edition). I've included a brief summary below that I wrote up for a friend.

For a more Canadian view, Gordon Pape (e.g. Low-Risk Investing in the 90s) is quite good.

Good luck!

Summary of The Only Investment Guide You'll Ever Need, by Andrew Tobias:

  1. Avoid get-rich-quick schemes. In fact, avoid any investment that promises to make you rich, but which you don't understand.

    Such schemes usually boil down to the following: take $5000 (borrow it if you have to), go to the nearest roulette wheel, pick a number, bet it all, and win $200,000.

    Also, you don't need to spend a lot of time studying investing, unless you want to become a professional. There's a lot of randomness in investing, so knowing more doesn't necessarily help much.

  2. It's usually much easier to save $100 than it is to earn an extra $200 -- you need to pay roughly $100 in tax on that extra $200 (your marginal tax rate). So getting your finances in order starts with spending less, rather than earning more.

    Lots of ideas for how to save money. The one I liked the best was to spend more time thinking about what you have (a 20" Panasonic with remote) rather than what you don't have (a 32" Sony with Dolby surround system).

  3. Coming up with a budget (i.e. a plan):

    Figure out your net worth (how much you own, minus how much you owe). Then figure out what your goals are -- what you'd like your net worth to be, say a couple years from now.

    Estimate your income and your expenses. Estimate your expenses high to begin with.

    If your goals and your expenses are out of whack -- there's no way you can save enough to meet your goals -- make a first pass through your expenses, seeing where you can trim them. Maybe bring down your goals a little. Go round and round on this until you've got your goals and your expenses in balance.

  4. Debt investments

    Once you've got some savings accumulating, what to do with them?

    Until you've got more than a couple thousand, it should simply go into a bank account. The interest rate doesn't really matter: you just want your money to be somewhere safe and liquid. You should have two or three months' worth of expenses socked away before you start thinking about anything more risky.

    After that, there's basically two kinds of investments: debt and equity. Debt is when you lend money, and get paid interest; equity is when you buy a piece of a company.

    Debt's easy to understand, but boring: you lend money to someone, and they promise to pay it back with interest. You know how much you're going to get, unless they go bankrupt. Generally, the longer you're willing to tie up your money -- up to five years for GICs, up to 30 years for bonds -- the more interest you'll get.

    Money, like any other commodity -- oil, wheat, pork bellies -- has a going price, determined by supply and demand. (And the Federal Reserve.) If there's a lot of demand for money, interest rates go up. If there's a lot of money available for lending, interest rates go down.

    (Note that if you've got a 10-year, $1000 bond that pays 6%, and interest rates go up to 9%, your bond is worth less than before: if you want to sell it to someone else, you have to sell it at a discount. And vice versa: if interest rates go down, you can sell your bond at a premium. So bond prices go up when interest rates go down, and vice versa.)

    The rule of 72 is useful to keep in mind. At n%, the number of years it takes an investment to double is 72 / n. So at 6%, it takes 12 years to double; at 7%, it takes 10 years; at 10%, it takes 7 years.

  5. IRAs / 401k / RRSPs

    Are something that you should definitely have. Since your savings are compounding tax-free (say at 7% instead of 3.5% after tax), they're growing much faster than they would outside the plan.

  6. Equity investments

    Are risky.

    Basically, you're buying a share in the future earnings of a company. Comparable to a magic wallet in which a dollar appears every year. How much would you pay for such a wallet? If the price was $10, the return every year would be 10%. If it was $20, the return would only be 5%.

    The price you'd be willing to pay depends on the prevailing interest rate -- if interest rates are at 6%, then a price of $10 would be a good deal, but not a price of $20. This is the price/earnings ratio: how much you have to pay to get $1 of earnings. With interest rates at 6%, you'd probably expect price/earnings ratios of 15 to 1.

    But there's also a lot of irrationality in the stock market -- stocks may be driven up and down by the conflicting emotions of greed and fear. This is particularly true for companies which are very well-known (like Cisco, which currently has a price/earnings ratio of 100; or even HP, which has a price/earnings ratio of 30).

    Also, if interest rates go up, there's a triple-barrelled effect on stocks: debt investments like bonds become more attractive, so money shifts out of equities into bonds; the economy slows down, so companies are likely to make less money; and people are less willing to borrow money to invest in stocks. This is how stock-market crashes happen.

    It still makes sense to invest in equities, because in the long term they should outperform debt investments -- the return should be higher because the risk is higher.

    To minimize risk:

  7. Diversification

    Given that we don't know whether the future is likely to bring inflation or deflation, diversify among different types of investments:

    In case of inflation, real estate and equity investments should maintain their value. In case of deflation, cash and debt investments should do well.

    In case of neither -- if the economy stays healthy and prosperous -- equity investments should do well.

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2 July 1998; updated 12 December 1999

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