Updated: Jun 15, 2020
If you are in your twenties or early thirties, it may never occur to you that you will stop receiving a paycheck at some point in your life. It can be temporary-like when you change your jobs. Or it can be permanent if you decide to retire.
For anyone who started their career in academia and still holds temporary positions (graduate students and postdoctoral fellows, for example), it may seem pointless to even think about planning to reach their financial independence. Your salary may barely cover your expense, especially if you are starting a family. You may not be qualified to receive benefits such as employer match for your contribution to retirement accounts.
However, what often falls off young academic’s radar are IRA and 403b retirement accounts. A simple fact: if you contribute post-tax income to these retirement accounts (Roth IRA or Roth 403b supplement), you can grow your investment portfolio tax-free.
Never receiving personal finance education, I did not know that even students can open IRA accounts for saving. You may ask what difference it would make to sock away $100 a month into an IRA account. Isn’t it better to set up retirement accounts once you get a job that comes with benefits and a much higher salary?
(Image source: www.quora.com/How-did-Warren-Buffett-become-so-rich)
Let’s run some thought experiments. If you invest $100 a month in index funds and keep your investment in your IRA account for 26 years, you will end up with $100,154, assuming annual returns at 8%. If you increase your monthly investment to $1000, you will become a millionaire in 26 years. On the other hand, if you wait for 7 years to open your investment account, you would have to save twice more ($2000 a month) to achieve the same end results in time: a million-dollar portfolio in 19 years.
Did you notice that you can save half the amount of money and still become a millionaire if you start to invest 7 years earlier? That is the power of compounding. By the way, you may not need a million-dollar investment portfolio to secure your financial independence. Here you can calculate how big your investment portfolio should be.
If I could travel back in time, I would open a Roth IRA account during my first year as a Ph. D. student, when I started receiving a salary. Had I invested $500 a month for 10 years, I would have increased my investment portfolio by 50% ($60,000 without compounding vs. $91,000 with 8% annual compounding). Because I can withdraw money from my Roth IRA account without incurring a penalty as long as the amount of withdrawal is less than my total contribution, I could have used my Roth IRA account as a high-yield savings account that has never existed in the United States for the last 10 years.
What if you don’t know anything about investing? You may be too busy to research individual companies for investing. In that case, I would recommend index funds that track the entire US stock market or large capital companies (S&P 500 for example). Because only strong, well-managed businesses survive these index funds as in the natural selection, you won’t get stuck with bad companies if you invest in index funds. Historically, total stock market index funds have provided 8% annual return and index funds charge much lower fees, compared to actively managed funds. However, you can expect potentially much better returns from investing in high-quality stocks.
There will be ups and downs in your investment portfolio. Sometimes you may see it losing half of its balance in a matter of months as in 2008. But if you have 30 years to grow your portfolio, it will always recover and gain faster following a recession. If you keep investing the same amount of money regularly through recessions in an auto-pilot mode, market downtimes will serve as opportunities since you would buy more stocks at cheaper prices (dollar-cost averaging).
Based on the performance of my investment portfolio for the last five years, I can tell you that the efficiency of dollar-cost averaging increases with the size of each contribution and the employer match. So, I recommend that you maximize your contributions to your retirement accounts while working for a generous employer.
If you can follow this simple rule - start to invest early and invest the same amount of money in index funds regularly for a long time, you will reach your financial independence before you are ready to retire, regardless of your income.