How to save a million dollars before you retire is easy and becomes a relatively straightforward and robotic process if you know the key ingredients to the recipe. It’s best to think of “how to save a million dollars” as baking a cake and the cake recipe (equation) has 5 parts to it. If you know any 4 of them, you can work out the 5th with relative ease. The five ingredients are as follows…
- Time (how far away your retirement or target date is)
- Rate (the rate of return that you are getting on your money)
- Starting Amount (how much money you are starting out with)
- Payments (how much are you going to put away every year), and
- Ending Amount (what you plan on ending up with)
Now that we have the key ingredients, there are 3 ways we can calculate how to save a million dollars before retirement. We can either do it with a pen and paper, use Microsoft Excel, or invoke the light saber of financial wizards, a financial calculator (my weapon of choice is the almighty Texas Instruments BAII Plus).Pen & Paper. We have to go to our introductory finance textbooks and reference the concept of annuity (bonds) to see how this works. Basically an annuity is nothing more than regular cash payments for a fixed period of time. The finance textbook defines annuity as a level stream of cash flows for a fixed period of time. So this means that a bond can be thought of as an annuity (a bond is nothing more than an “IOU” on which you pay back the money you borrowed in fixed payments over a period of time at a given interest rate). Now, what if we “flipped” the concept on its head and instead become the bond buyers?
Say, for instance we approach a wealthy man with lots of resources (let’s call him Mr. Market) and make him an offer. We know that Mr. Market is always looking to grow his money. To do this, he has to produce goods and services that people will buy. The more goods and services he brings to the market (people around him), the more his wealth grows over time. But to bring the goods and services to the market, he doesn’t want to use all of his money. He would rather spread the risk around (pool his money with other people) and spread the wealth around as well (share the profits with his partners and fellow investors). So Mr. Market has two agendas that both go together like flip sides of a coin. The first is to spread or limit risk and the second is to grow his money or earn a decent return on his invested capital.
Now, he borrows money from the people around him and he usually pays it back when he’s done with the project. The operative words here are “usually” or “more often than not” and that is the key to making money and getting rich.
And that is the key to making money and getting rich and lets see why this is deeply related to one of the most fundamental concepts in modern finance.
There can be no return without any risk. Let me explain to you why this has to be true almost all of the time.
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