A month or so ago, I received an email from my friend Barry, author of both theFinancialPage and AssetAllocation blogs. Attached was a copy of a letter written by a husband and wife to their teenage daughter. I like the letter so much that I asked permission to reprint it in full. The only information I changed (other than formatting the letter for posting) was the information in the section that talks the growth of $1,000 at a 10% rate of return. Rather than use the rule of thumb that money doubles “about” every 7 years, I used numbers taken directly out of an Excel spreadsheet. The rest of the letter was posted word-for-word as I received it.
I’m posting this because I think it is a great idea. Sure, not all kids will take an interest in this, but SOME WILL! I’m going to implement something like this with my kids. If you have kids, I urge you do the same. Jatie is a very lucky little girl!
Now, here’s the letter (it’s long, but worth your time):
Hereâ€™s a copy of the letter that my husband and I created on the occasion of our daughterâ€™s first foray into investing. Up until age 14, she saved her money in a bank account. At age 14, we took her savings of $1,000 and opened an investment account in her name. To mark this event and also to maximize the learning opportunity about investing, we gave our daughter the following letter. If this letter, in whole or in part, would be useful to you in creating a similar letter for your child, please feel free to use it. (If you wish to use this letter in a different manner, please contact me at firstname.lastname@example.org to discuss how you would like to use this letter. Thank you.)
Letter to Our 14-year old Daughter on the Occasion of Opening Her First Investment Account
Congratulations!!! Youâ€™ve managed to save a little over $1,000 in the bank account that we call your â€œmillionaire account.â€ This is money youâ€™re saving for when youâ€™re much older and ready to retire. This money is NOT:
- to pay for your college education
- to put a down payment on your first house
- to pay off credit card debt (which we hope you donâ€™t ever incur)
- to take a luxury trip around the world
This is money is exclusively to give you a head start on becoming financially independent â€“ and financially secure in your later years. It took about three years for you to save $1000, but you did it! Hereâ€™s how:
- Out of your $10.00 a week allowance, each week we deposited $3.00 automatically into your millionaire account at an online bank. (Note to the reader: Our childâ€™s allowance for the past few years has been $10.00 per week, and it was divided up as follows: $3.00 for her millionaire account; $3.00 for her personal choice miscellaneous small purchases; $3.00 for long-term purchases that she needs to save up for; $1.00 for charity)
- We also deposited $3.00 a week in matching funds into your millionaire account. (Note: A total of $6.00 a week — $3.00 from her allowance and $3.00 from our matching funds — went into her millionaire account. And in approximately 3 years, she had saved almost $1000.)
- You saved (or reinvested) the interest that your money earned ($71.52.)
As you know, $1,000 is a lot of money…
What does $1,000 represent?
- Many poor people in developing countries live â€“ though not very comfortably — on just $2.00 a day. So $1,000 is enough to support one of these people for 500 days (about a year and four months)!
- A typical grande-size coffee at Starbuckâ€™s costs about $3.75. So your $1,000 is equal to about 266 drinks — or enough to buy a Carmel Macchiato every weekday of the year for an entire year. (You might get sick of them if you had so manyâ€¦but thatâ€™s beside the point.)
- The minimum wage in the United Sates at this time is just $5.15 per hour. At that rate, a person would have to work 24, eight-hour days to earn almost $1,000.
- When I substitute teach, I earn $13.28 per hour. I would have to work for nearly 11, 7-hour days to earn $1,000.
- As incredible as it may seem, some high-priced doctors and lawyers make $500 (or more) per hour. It would take them just two hours to earn $1,000!
Where your money has been
Your $1,000 was on deposit at ING Direct and Cardinal Banks. At ING your money currently earns 3.75% Annual Percentage Yield (or APY) and at Cardinal Bank 5% APY.
Interest rates â€“ APY
When talking about interest rates, you always want to know the APY or Annual Percentage Yield. Thatâ€™s because APY tells you how much youâ€™re really making on your money. APY is the rate that reflects the total amount of interest youâ€™re going to make in one year â€“ that is the interest on your investment plus the interest on your interest.
Over the past couple of years, youâ€™ve earned a total $71.52 in interest. Thatâ€™s money that your money earned for you — money you earned while you were busy doing other things, including sleeping.
While $71.52 is a nice piece of change, I imagine youâ€™re somewhat surprised that you didnâ€™t earn more interest. So let me explain why:
1. Interest rates happened to be very low during the time your money was invested. (Thatâ€™s called tough luck.)
2. You started with only a few dollars and very gradually added more money, so for most of the time that your money was invested, you didnâ€™t have very much money earning interest.
3. Your money was earning interest for a little more than three years, and thatâ€™s an extremely short time when it comes to investing.
But because youâ€™re only 14, you have time on your side. With time â€“ lots of time — $1,000 can earn an amazing amount of money for you. Imagine that you keep your $1,000 invested for 50 years (by which time youâ€™ll be 64) or 51 years (by which time youâ€™ll be 65 and perhaps ready to retire). At 5% APY (what you might expect from a bank account), money doubles approximately every 14 Â½ years. So hereâ€™s how $1,000 will grow at 5% APY over 50 years:
- By year 14 Â½ (when youâ€™re 28 Â½), you would have about $2,000.
- After 14 Â½ more years, or by year 29 (when youâ€™re 43), you would have about $4,000.
- After 14 Â½ more years, or by year 43 Â½ (when youâ€™re 57 Â½), you would have about $8,000.
- After 6 Â½ more years, or by year 50 (when youâ€™re 64), you would have about $11,500.
- After 1 more year, or by year 51 (when youâ€™re 65), you would have $12,040.
In other words, when youâ€™re 65, your $1,000 will have grown to $12,040. That means you will have made $11,040 on your 51-year investment of only $1,000!
But is $11,040 a good return on a $1,000 over a 51-year period? To answer this question, you need to know what other investment returns you might get on your money if you invested it in something other than a bank savings account.
The famous Professor from your favorite Yale University
According to Professor Ibbotson:
“The compound average nominal rate of return for common stocks was 10.7% over the period 1926-2001.â€ (By the way, a â€œnominal rate of returnâ€ is a rate of return that does not subtract for the effect of inflation.)
Translated, what the Professor is saying is that if youâ€™d invested in the U.S. stock market for the entire 75 years between 1926 and 2001, you would have made, on average, 10.7% per year on your money.
At a 10% return, money doubles approximately every 7 years. So hereâ€™s approximately how $1,000 will grow at a 10% return over 50 (or 51) years:
- By year 7 (when youâ€™re 21 years old), you would have $1,949
- By year 14 (when youâ€™re 28), you would have $3,797
- By year 21, (when youâ€™re 35) you would have $7,400
- By year 28, (when youâ€™re 42) you would have $14,421
- By year 35, (when youâ€™re 49) you would have $28,102
- By year 42, (when youâ€™re 56) you would have $54,764
- By year 49, (when youâ€™re 63) you would have $106,719
- By year 50, (when youâ€™re 64) you would have $117391!
- By year 51, (when youâ€™re 65) you would have $129,130! WOW!
As you can see, after 51 years, your $1,000 investment will have grown to $129,130! That means you will have made $128,130 on your 51-year investment of only $1,000! Thatâ€™s pretty amazing, isnâ€™t it!
Now, letâ€™s compare the money you end up with if you get a 5% return vs. the money you end up with if you get a 10% return on your $1,000. In round numbers,
- At 5%, after 51 years (when youâ€™re 65), youâ€™ve made $11,040.
- At 10%, after 51 years (when youâ€™re 65) youâ€™ve made $128,130.
As you can see, when the interest rate doubled (from 5% to 10%), your earnings over a 51 year period grew by more than a factor of ten â€“ from about $11,000 to about $128,000!!
Hmâ€¦you invested the same amount ($1,000) for the same amount of time (51 years). The only difference was the rate of return on your investment –5% or 10%. This certainly shows that compound interest â€“ or interest on the interest â€“ has the power to â€œsupersizeâ€ your investment.
Albert Einstein was interested in compound interest
By the way, Albert Einstein was very interested in compound interest and he discovered a simple formula for finding out how long it takes for an investment to double. He claimed that this formula â€œis the greatest mathematical discovery of all time,â€ and the â€œ9th wonder of the world.â€ So what is his formula? Itâ€™s the â€œRule of 72.â€
The Rule of 72
The Rule of 72 states that to find the number of years it takes to double your money at a given interest rate, you simply divide the interest rate into 72.
- 72 divided by 5 = 14.4 years
So at a 5% return, it takes about 14 Â½ years to double your money.
- 72 divided by 10 = 7.2 years
So at a 10% return, it takes about 7 years to double your money.
So how can you get a 10% rate of return on your money?
Forget about banks. The interest they give is always low â€“ whether itâ€™s in a savings account or a money market account. It doesnâ€™t matter. Either way, the bank probably makes more money on your money than you do.
Based on the returns of the stock market over the past 75-80 years, we can now see in hindsight that one could have made a 10% return by investing in mutual funds that are made up of stocks. (IMPORTANT NOTE: Historical returns do not predict future returns. But since we donâ€™t know what other data to use to predict future returns, we are going to talk about past returns –always keeping in mind that the past may or may not repeat in the future.)
But you should never invest only in stocks. Thatâ€™s too risky. You should invest in stocks and bonds. Most bonds are less risky than stocks. Having some bonds in your portfolio keeps you from losing too much money â€“ which keeps you from wanting to do foolish things like take your money out of the stock market.
When youâ€™re as young as you are, Jatie, itâ€™s good to have plenty of stocks in your portfolio. So the Vanguard Target Retirement 2045 which is 88% in stocks and 12% in bonds is a good choice for you because itâ€™s a well-balanced portfolio for someone your age or a little older who is saving for retirement. (Source: Vanguard.com)
And, historically speaking, a portfolio of 10-20% bonds and 80-90% stocks has returned 10.1% (1960-2004.) Of course, it could do betterâ€¦and it could do worse. (And you knew that already, didnâ€™t you? â˜º).
Another good thing about the Vanguard Target Retirement 2045 fund is that with every passing year, the percent of stocks in the fund decreases and the percent of money market funds and bonds increases. Why is that? Thatâ€™s because as you get closer to 2045 or when you might need to use this money for your retirement, you need to be sure that the money is there for you to draw on!
You see, the more stock in a fund, the more risky that fund is. The more money market funds and bonds (generally speaking) in a fund, the less risky the fund is. And by risk I mean the chance that youâ€™ll lose some or most of your money because the market went down. When youâ€™re young itâ€™s OK if the market goes down and stays down for a while; hopefully it will have time to recover and youâ€™ll make up for your losses by the time you retire. But when youâ€™re close to retiring and the market goes down, you donâ€™t have time to wait for the market to recover because you need the money to live off of in your retirement. Thatâ€™s why the Target Retirement type funds all get more conservative (contain more money market funds and bonds) and less risky (contain less stocks) as time goes on.
Riskâ€¦always consider the risk
But wait a minuteâ€¦ Mutual fund investing isnâ€™t the same as putting money into a savings account at the bank. When you put money into a savings account, your balance (or the money in your account) will never be less than the money you put into it. In fact, it will always be equal to what you put in plus the interest that accrues. But when you put your money into a mutual fund, even a mutual fund like Target Retirement 2045, you take the chance (the risk) that your balance will either go up, down, or not change. Of course, up or even no change, is always better than down. But down is a real possibility. Just a few years ago, the stock market took a big dive. And when the stock market takes a big dive, thereâ€™s no telling how long itâ€™s going to take to recover from that big fall. It can take years and even decades.
This means that over the short term — from a few days to even many years — you could lose money. But over the long term â€“ 10 years or more, if youâ€™re lucky — you can expect to make money. At least thatâ€™s what the past history of the market has shown.
How to get started investing in mutual funds
How much money do you need to start investing in mutual funds? At Vanguard, $1,000 is the magic number.
(Note to the reader: There have been some changes at Vanguard since this letter was written. The current minimum to invest in a Vanguard Target Retirement fund is $3,000. The current minimum for the Vanguard Star fund is $1,000. So if the child has $1,000, he/she could invest in the Star Fund. When the account grows to $3000, he/she could move the money, if desired, to the Target Retirement fund of choice. To transfer the money to the Target Retirement fund, you might want to wait until the child had earned $3000 in one year from paid employment. Then you could move the $3000 thatâ€™s accumulated in the Star fund into a Target Retirement fund â€“ in a Roth IRA in the childâ€™s name.)
But, as you know, Jatie, just because you can do something, doesnâ€™t mean you should. So are you comfortable with the idea of investing in mutual funds? Are you sure you will be willing to keep your money invested in Vanguardâ€™s Target Retirement fund even when you discover that you lost money on paper?
Just one question
Please answer this question:
I, Jatie, am _________ with the idea of investing my $1,000 in Vanguardâ€™s Target Retirement 2045 fund, a well-diversified stock and bond mutual fund.
b. not comfortable
c. not sure
If you answered â€œa,â€ then letâ€™s get started!
Vanguard Target Retirement 2045 fund
The Target Retirement fund contains three stock funds and one bond fund:
- Vanguard Total Stock Market Index
- Vanguard European Stock Index
- Vanguard Pacific Stock Index
- Vanguard Total Bond Market Index
Each of the stock funds contains many different stocks and the bond fund contains many different bonds.
Target Retirement fund is diversified and thatâ€™s a very good thing
Because your Target Retirement fund contains many different stocks and bonds, itâ€™s â€œdiversified.â€ Diversification is good because it lowers the risk (but doesnâ€™t eliminate the risk) that you will lose money. This is because when you have a lot of different assets in your portfolio, itâ€™s more likely that at any one point in time while one of your assets (for example, stocks) may be losing value, another asset (for example, bonds) may be gaining value.
So diversification makes investing less of a â€œbumpy ride.â€ It keeps the highs lower and lows higherâ€¦.and diversification actually increases your long term return for a given level of risk! So diversification is VERY good.
Ready, set, go?
To get started investing at Vanguard thereâ€™s paperwork that must be filled out. We can fill this out and send it right in because the more time your money is in the market, the better.
Remember, as the wisest investors say, â€œitâ€™s time in the market; not timing the market that matters.â€
The new deal for 2006
And by the way, hereâ€™s the new deal that dad and I are willing to offer you in 2006:
1. Going forward we will continue to give you $3.00-a-week allowance to save in your ING Direct millionaire account. (Thatâ€™s $156 a year.)
2. Dollar for dollar, we will match the $3.00-a-week allowance money that you save in your ING Direct millionaire account. (Thatâ€™s another $156 a year.)
3. We would like to suggest that in 2006 you save $100 out of your entrepreneurial earnings. (Thatâ€™s $100.)
4. Dollar for dollar, we agree to match the entrepreneurial earnings that you save. So if you save $100 from your earnings, weâ€™ll match the amount you save, dollar for dollar. (Thatâ€™s another $100.)
5. Each quarter (or every three months), you will get a statement in the mail from Vanguard explaining how well or how poorly your Target Retirement fund is doing. When you get this statement, weâ€™ll go over it together â€“ both the paper and the on-line versions. If you can demonstrate that you understand your statement and know how to file it properly, weâ€™ll give you 50% of the money that your account made — from capital gains, dividends, and interest. (Of course, if your fund lost money, we
wonâ€™t ask you to give us 50% of the losses!)
In summary, in 2006, following the five step plan given above, you should be able to save at least $512 and only $100 of that money will come from money that you earned. The rest will actually be money that we give you.
And just as soon as you have $100 saved up in ING Direct, weâ€™ll go online and have that money transferred from your ING account to your Vanguard Target retirement fund account. (Note: $100 is the minimum amount of money you can add to this fund at one time.) We always want to move your money out of ING Direct and into Vanguard as soon as we can so it wonâ€™t languish at ING Direct only earning only 3.75% APY — or something like that.
Predicting the future
Soâ€¦letâ€™s take a look at what MIGHT happen:
- At the start of 2006, Jatie was 14, and she opened her Target Retirement 2045 account with $1,000.
- By the end of 2006, she was 15, and she had added $512 to her account.
- Each year after that she saved just $100 more than she had saved the year before.
- So in 2007 she saved $200 and in 2008 she saved $300, etc. Her parents continued to contribute as they had before.
- By end of 2007, Jatie was 16, and she had added $712 to her account.
- By end of 2008, Jatie was 17, and she had added $912 to her account.
- By end of 2009, Jatie was 18, and she had added $1112 to her account.
- By end of 2010, Jatie was 19, and she had added $1312 to her account.
- By end of 2011, Jatie was 20, and she had added $1512 to her account.
- By end of 2012, Jatie was 21, and she had added $1712 to her account.
- By end of 2013, Jatie was 22, and she had added $1912 to her account.
- By end of 2014, Jatie was 23, and she had added $2112 to her account.
- By end of 2015, Jatie was 24, and she had added $2312 to her account.
So at the end of 2015 when Jatie was 24, she had a total of $22,628 in her account. This is the sum of her $1,000 starting contribution, her yearly savings, her interest/return on investment â€“ through the age of 24.
What did Jatie do with her $22,628?
Since Jatie is a smart young woman, at age 24 she kept her $22,628 invested. Even if JT never adds one more cent to her account (which is not what weâ€™re recommending), at a 10% rate of return on her investment, over 51 years or by the time sheâ€™s 65, she will have $1,126,539 in her Millionaire Savings account!
Thatâ€™s the good news. Butâ€¦
Fifty years from now when your Target Retirement account balance is $1,126,539, you wonâ€™t really have as much money as you may think. Why not? Because over time money become worth less. Why? Because of inflation.
Youâ€™ve heard grandma say that she used to be able to mail a letter for three cents and buy a loaf of bread for five cents. And when I was as kid, I used to walk to the corner candy/drug store and buy a candy bar for a penny. And in 1950 my parents paid $25,000 to buy the really nice house we lived in.
As you know, today all of these things cost a lot more.
- A first-class stamp costs 37 cents — 3 cents.
- An inexpensive loaf of bread costs about $2.00 — not 5 cents.
- A candy bar costs 69 cents — not a penny.
- A nice but not expensive house in our locale costs at least $400,000 –not $25,000.
Soâ€¦as a result of inflation, everything is more expensive today than it was when I was your age. And as a result of inflation, when youâ€™re my age everything will be a lot more expensive than it is today.
Currently the inflation rate is 3% and thatâ€™s not a lot by historical standards. But the rate of inflation varies. It could be more or less in the future and no one can predict what it might be â€“ not even the smartest person.
But what we can predict is that at an inflation rate of only 3%, your money will be worth half as much in purchasing power every 24 years. (72 divided by 3 = 24) So in 24 years the purchasing power of your money will be reduced to one-half of what it is today. And in 48 years the purchasing power of your money will be reduced to one-quarter of what it is today.
What does that mean? It means that when youâ€™re 65, your $1,126,539 will be worth only about one-quarter what itâ€™s worth today or $281,634. In other words, when youâ€™re 65 the $1,126,539 will buy about what $281,634 will buy today.
Moral of the story â€“ Keep on saving!
The moral of this â€œstoryâ€ is: SAVE, and save some more!
Even though youâ€™re getting a very valuable head start by starting a serious savings and investing program when youâ€™re still young, you have to keep on SAVING!
Rule of thumb
As a rule of thumb, Jatie, save at least 20% of the money that you earn. I wish I had done that. Dad, on the other hand, was a good saver. When he was in graduate school (age 22), he started his savings plan. Out of the first $25 he earned, he put $5 or 20% into savings. (What did he do with the rest of his earnings? As you might expect, he bought a radio, a Coke and a snack.)
Based on historical returns (that may or may not repeat, of course) it is likely that you will have $1,126,539 when youâ€™re 65 years old by saving AT LEAST of your own money:
- $100 in 2006
- $200 in 2007
- $300 in 2008
- $400 in 2009
- $500 in 2010
- $600 in 2011
- $700 in 2012
- $800 in 2013
- $900 in 2014
As long as dad and I contribute our share of the money you save too:
- $412 in 2006
- $512 in 2007
- $612 in 2008
- $712 in 2009
- $812 in 2010
- $912 in 2011
- $1012 in 2012
- $1112 in 2013
- $1212 in 2014
- $1312 in 2015
And we know you can do it
When you were a little girl I did an experiment with you. You didnâ€™t know about it. I put a marshmallow on the table and told you that if you waited for 10 minutes until I got back and didnâ€™t eat the marshmallow while I was gone, Iâ€™d give you two marshmallows when I returned. But if when I came back you had eaten the marshmallow, I wouldnâ€™t give you a second one.
What did you do? You waited until I got back. And then I gave you two marshmallows which you promptly devoured with a big grin on your little face.
This is the same experiment that psychologists have done to demonstrate that some young children possess the inner control to defer gratification and some donâ€™t. According to this experiment and to what dad and I have observed of your choices in your life, we feel confident that you can defer gratification. Therefore we know that you can set yourself a savings plan and stick to it.
By the way, now you know 1,000 times more than either dad or I did about saving and investing when we were your age! We hope you will put your knowledge to use to create wealth for yourself â€“ starting today. We know you can do it!
With much love,
Mom and Dad â€¦and, of course, Marco P.
Note to the reader:
For our daughterâ€™s benefit, along with this letter we also included a slightly revised version of a story presented in the book, Sound Mind Investing, pgs. 63-64. In this story Jack saves $6,600 (his paper route earnings from ages 8-18). Jill saves $80,000 over 40 years starting at age 26. They both earn the same return. Jack ends up with more money by the time theyâ€™re both 65 even though he saved less than Jill. This is because when Jack was 26, the age at which Jill began saving, the interest earned in his account was more than the $2000 Jill was putting in.
The moral is: invest early and often â€“ even small amounts can make a big difference.