Hey friends! This is Neil and thanks for tuning in to this edition of Neil$letter.
Last time, I talked about the difference between playing financial offense and playing financial defense. Today, we’re going to talk financial offense. If there is one thing I could tell young people especially, it is to open a Roth IRA and start contributing as soon as possible. We’ll go over Roths in depth, but first, let’s look at how your wealth can grow in such an account.
Compound interest for superheroes 📈
You may have heard of compound interest before, but for those who haven’t, let’s do a quick summary. In wrapping your head around compound interest and financial offense, it’s very helpful to learn to think in terms of percent signs %, or percent change. For instance: “My Roth IRA went up 16% this year” or “This bond yields 4% annually” or “Because I took a 50% loss on that stock sale, it will take me a 100% gain of the proceeds to get back to break even.”
This is important, because it allows us to compare the returns of different investments. Just for the sake of discussion, let’s look at some options and assign a “back of the envelope” sample range of returns to them. (These figures are smoothed out over a long period, say 10+ years. In any given year, the ranges could be quite different. And lastly, these figures are more “backwards looking” than may be true for the next few years.)
Holding cash in a savings account or money market returns 0% to 2% each year
Holding bonds in a brokerage account returns 1% to 7% each year
Holding gold in a brokerage account returns 4% to 8% each year
Holding stocks in a brokerage account returns 6% to 10% each year
Let’s take the midpoint of each range and just say that on average, cash yields 1%, bonds yield 4%, gold returns 6%, and stocks return 8%.
From there, we can plug the returns into a compound interest calculator, and see what *might* happen if we hold these things long into the future (again, acknowledging that we don’t really know what future returns will look like).
If we start with $100, and hold for 10 years:
With cash compounding at 1% each year, we have $110 at the end
With bonds compounding at 4% each year, we have $148
With gold compounding at 6% per year, we have $179
With stocks compounding at 8% per year, we have $216.
Are you seeing the geometric magic at work?
To really drive the point home, let’s look at what happens over 40 years. Also, let’s say that in those years, you become a better investor, so your stock returns are able to go from an “average” 8% up to a superior 9%. In 40 years:
$100 in cash yielding 1% annually turns into $149
$100 in bonds yielding 4% annually turns into $480
$100 in gold returning 6% annually turns into $1,029
and $100 in stocks returning 9% annually turns into $3,141. (An 8% return gets you $2,172, nearly a $1,000 less)
One way I think about this is that for every $100 I spend now, in 40 years, I’ll have roughly $3,000 less. That kind of thinking may be anxiety-provoking or counter-productive for some, so I encourage you to play around with it. For me, the point is that for every expense now, there is usually a future financial tradeoff. Knowing this makes it easier for me to say “no thank you” to things I want but don’t need, and thus, to put that money into a long-term account instead of spending it.
So, just based on a compound interest spreadsheet (note: you can go to File → Make a copy, and play around with the numbers yourself if you like!), there is a strong financial incentive to get a high rate of return, and to hold that for as many years as possible.
My interpretation? Start early, and invest aggressively.
What is a Roth IRA?
I’m going to let Investopedia do all the talking here, but the short and sweet is that Roth IRAs are surprisingly flexible accounts where you can do tax-sheltered investing for retirement. Unlike workplace 401(k)s, these accounts must generally be started and “driven” by you. This is admittedly a small pain to setup, fund, research, and (potentially) manage. But in exchange, you always feel like the account is “yours” rather than your employer’s, and you get tons of options with it.
Why Roth IRAs are pure financial magic 🌈
You can start one early (as soon as you have earned income)
You can invest aggressively
You can invest in a extremely wide array of things
No tax paid on withdrawals (after age 59½)
You can also withdraw tax and penalty free under certain circumstances
Worst case, if you need to withdraw under a “non-qualified distribution" you can still get most of your money back
All added up, this makes Roth IRAs an ideal instrument for working people to grow their wealth, in a flexible, low-risk, potentially high-reward way.
Can’t someone else do it?
Historically, pensions covered the retirement needs of many people in the United States, as recently as just a few generations ago. In the late 20th century, however, the working culture became much less of a “one workplace for life” and the Reagan Administration passed a series of laws that would ultimately shift the burden of providing retirement income from the employer to the individual, as most employers swapped out pensions for 401(k)s.
Add to this a lack of leadership on social security (in my opinion), and you have a good recipe for many people being poor in old age and increasing bifurcation of the economy.
My interpretation? Unless you’re born into wealth, you have to grow it and nurture it yourself (assuming you want it). That said, there are things like Spousal Roth IRAs (for your partner), and Custodial Roth IRAs (for your child). Aside from family, though, I agree with this excellent Ted talk, that the cavalry isn’t coming:
Wrapping Up
For me, starting a Roth IRA in my mid-20s turned out to be one of my best financial decisions. I had no idea the stock market would do so spectacularly well from 2008 all the way to the end of 2021. My only “regrets” are that I didn’t start a few years earlier or put even more in. I consider my Roth IRA to be my most important source of wealth generation / “financial offense” - with real estate and 401(k) accounts taking second place.
If I were back in my 20s today, I might pick one of the biggies, and just let ‘er rip.
Ultimately, only you and your loved ones can know what is best for you financially. Talk with a licensed financial advisor or planner to help you figure out your best course of action. Who knows, perhaps one day, you will look at your Roth IRA like this guy looks at monorails:
If you’ve enjoyed this post, please smash like and share it with someone! Thank you for reading.
-Neil
PS. I’m going to add some fun extras to each post to further pepper in my personality. I’ll attach one or more things that I’m enjoying / I think are worth sharing.
Right now, that’s the new Dungeons & Dragons: Honor Among Thieves movie that just hit theaters this last weekend! If you’re even remotely interested in D&D or fantasy, I consider it one of the highest quality movies of the genre in ages, and a must-watch:
The more I read, the more I know I know very little. These articles are helping ground a lot of fundamentals which, I think, should have been taught in HS.
Excellent article, I am late to the financial game of life, your articles help me understand and take the ignorance and fear out of investing for me!