[youtube=http://www.youtube.com/watch?v=XpvtSHjKIi8&w=560&h=315]
In a previous post we looked at a simple compounding interest example. It showed that if you start saving early in your life you can end up with more money in retirement than if you started later in life, even if you saved a lot more once you start saving. Today we will look at another example that will deepen your understanding of compounding interest.

For today’s example we will look at two scenarios for a 25-year-old and two scenarios for a 45-year-old. In each case we will compare which saving and investing scenario is better:

• Saving 6% of your salary and gaining 10% per year on your investments
• Saving 10% of your salary and gaining 6% per year on your investments

For all the scenarios we will assume that employment starts at age 25 with a starting salary of $45,000 per year. Every year the salary will increase by 3%. For the 25-year-old, we will assume he starts saving right away. For the 45-year-old we will assume he starts his saving at age 45 (no savings prior to age 45). We will assume retirement at age 65 in all scenarios.

First we will look at the 25-year-old. Below is a chart of the two scenarios:

As you can see if you have a long investment horizon (40 years in this case) having a high investment return is more beneficial than saving a higher percentage of your salary. Of course, we would like to have high saving and high returns, but if you had the option you’d want higher returns.

Next we will look at the 45-year-old. Below is a chart of the two scenarios:

In this scenario we see the exact opposite. When we have a shorter investment horizon (20 years in this case) having a higher savings rate is more beneficial.

There are important conclusions you can draw from this example. It is common for many people to be within 20 years of retirement and not have enough in savings to easily meet their ultimate financial goals. Those who are behind in their savings often want to take large amounts of investment risk to try to boost their account balances. As we can see from the example above, saving a higher portion of one’s income has a greater impact than higher returns (depending on the %’s used, of course). Adding investment risk also increases the likelihood of losing large amounts of money due to a bear market as one nears retirement age.

For most nearing retirement, increasing their savings rate and taking less investment risk is the smarter choice.