Social Security retirement benefits aren't disappearing any time soon, but it's getting more important for Americans to build their own retirement fund. If you don't save enough during your working years, then your lifestyle could really suffer during your golden years. The process of turning $25,000 into $250,000 is surprisingly simple, but it requires discipline and patience.
Compounding returns over time
The time value of money is a core concept of investing and finance. This principle basically says that a dollar today is worth more than a dollar tomorrow. That's because capital can be invested for growth over time. That might seem like an obvious observation, but it's directly related to the process of turning $25,000 into $250,000.
Compounding growth is the engine that drives huge gains over long time spans. If your rate of return remains constant, the dollar value of returns continues to rise over time, and the value of invested capital expands. If you invest $20,000 today that delivers a 10% rate of return over the next year, then you'll be putting $22,000 to work next year. That has a major impact when the process is stretched out over decades.
Rate of return
Some people are looking for investment opportunities that fuel hypergrowth. Numerous small growth stocks, cryptocurrencies, and alternative assets have delivered massive growth at various times, but it's probably not a good idea to build a retirement plan around moonshots. These are often equivalent to get-rich-quick schemes. It's important to keep your expectations grounded in reality.
Over the long term, stock market returns should modestly outpace economic growth. Over the past 20 years, the S&P 500 has delivered a 7.5% compound annual growth rate (CAGR). The Nasdaq has delivered an 11% CAGR over the same period, powered by a handful of high-growth tech stocks. Obviously, returns aren't smooth and equal over time. The market moves in cycles, bouncing above and below a long-term trend line. That's one of the reasons that portfolio allocation has to change with investor age.
With an 8% average annual rate of return, $25,000 would grow to $251,000 after 30 years. The account value would just about double every nine years. If you're lucky and talented enough to beat the market by a few points and get a 10% CAGR, that $25,000 would grow to more than $435,000 over a 30-year period.
You don't have to settle for the market returns produced by index funds, but there's a limit to what you can reasonably accomplish through stock picking. Talented investors can slightly outpace the market over the long term, but it's extremely rare for anyone to consistently outpace major indexes by a wide margin. If your retirement plan hinges on a 15% average rate of return, consider serious revisions to that strategy -- that's dangerously close to the bogus promises made by financial criminals like Bernie Madoff.
Ultimately, everyone can enjoy big returns with patience and a relatively simple buy-and-hold strategy.
Time horizon and starting early
Asset growth is a function of the rate of return and time. With rare exceptions, a longer time frame will result in more growth. This tendency is exacerbated by the need to limit volatility as investment time horizons get shorter. For example, investors who are getting closer to retirement can't risk big drawdowns, so they typically hold higher quantities of less-volatile investments like cash, bonds, and dividend stocks. The measures that reduce volatility also limit growth potential, so it's especially difficult to squeeze huge gains into short time frames.
This underlines the importance of an early start to saving and investment. If you're trying to turn $25,000 into $250,000, it's going to take a few decades. Start saving for retirement early and often, even if it's modest at first. Investors who wait too long to start building assets can never get those years back.
Don't forget taxes
Taxes are a final important consideration. Depending on where these retirement assets are kept, you won't be able to realize the full value of your account. Taxes will reduce the net gains.
Qualifying withdrawals from a 401(k) or traditional IRA are taxed as ordinary income, so the tax rate depends on your bracket. If these funds are held in regular brokerage accounts, then you'll owe capital gains taxes on any realized gains. Roth IRAs are one of the few vehicles that allow retirees to realize their full accounts. Roths are funded with post-tax dollars, but assets in these accounts grow and get distributed without any further tax liability.