Building Wealth Over Time

By John Morton, Scott Niederjohn, and Signè Thomas

When you start your financial life on your own, building

wealth for the future may be the last thing on your mind. After all,
it is difficult enough to break-even at the end of the month on a
starting salary. The opportunity cost of saving may be a spacious
apartment, a new car, a big-screen TV, or a vacation. You may
reject the very idea that saving for the future is important. A good
life means getting together with friends and family, helping those in
need, enjoying hobbies, and having a satisfying job. You can
achieve all these goals more easily if you limit debt and build wealth.
Buying less stuff that will lose value and more stuff that will gain
value requires short-run sacrifices to reach long-term goals. The
laws of economics apply to building wealth; there is no free lunch
in saving and investing.

Financial Markets
Financial markets can help you build wealth. Markets, as you
know, are physical or electronic systems through which buyers and
sellers interact and determine prices. Prices in markets for stocks,
bonds, and mutual funds reach equilibrium through the same
process as any other good or service. Millions of bits of
information flow and interact in market transactions, making it
difficult to predict how current and future events will affect supply,
demand, and equilibrium prices. The market process heavily
influences the ultimate investment strategies that build wealth.
While the Internet and online trading have transformed the way
financial markets operate, they have not changed the basic risks
and rewards of investing.

Rules for Building Wealth

Before IRAs and 401(k) plans, retirement was simpler—all
people had to do was put in their time at work, retire, and collect

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their pension checks. Between the company pension and Social
Security, most retirees figured they had it made. If they had
managed to save a little extra, it was just that: extra.
These days, that all has changed. For most workers, traditional
defined-benefit pension plans that provide a fixed payment on a
regular basis are a thing of the past. Few people expect Social
Security to provide the majority of what they hope to spend in
retirement. As a result, your ability to save and invest on your own
will likely determine your financial situation in retirement.
Making use of compound interest, holding for the long term,
taking advantage of employer matching, and diversification are
widely regarded as successful strategies for building wealth. We
discuss each strategy in detail below.

1. Save and invest early and often.

The amount of your initial savings or investment is called the
principal. This is money you already have, and you are postponing
spending it. The amount your savings earn is called interest, which
is stated as a percentage. The amount your investments earn is
called the rate of return because it includes interest, dividends, and
capital gains. The interest rate and rate of return are expressed in
yearly terms and are known as the annual percentage rate of return.

Rule of 70: # of years required to double your investment

70
≈
annual percentage rate of return

The reason for saving and investing early and often is because
of compound interest. Compound interest is interest paid on
interest. “The Rule of 70” is a way to illustrate compound interest.
Divide 70 by the annual percentage rate of return; the answer
equals the number of years it will take to double your money. 1 Let’s
say your principal is $10,000. The table below indicates how long it

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will take to turn $10,000 into $20,000 at different rates of return:
1%, 5%, 7%, and 10%.

Annual Rule of 70 (Approximate)

Percentage Rate Calculation Years to Double
of Return Investment
1 70 ÷ 1 70
5 70 ÷ 5 14
7 70 ÷ 7 10
10 70 ÷ 10 7

You can see that the annual percentage rate of return makes a
big difference. There is often a trade-off between risk and return.
Because time is the critical factor for compounding to work
best, it is important to begin planning for retirement at an early age.
Starting to save early allows savings to earn interest on the interest
earned previously. Your money works for you. Allowing savings to
grow over many years is also an important strategy for success.
Consider this simple illustration as an example: Let’s say you
invest $200 a month beginning at age 25, and you earn 7 percent
annually on that money. By the time you turn 65, you will have
made 40 payments going into the investment, and at a 7% annual
return you will have about $512,662.78 saved up. If you wait until
you're 35 to begin saving, assuming the same monthly investment
and rate of return, you will have amassed less than half that
amount—about $242,575.21. This illustration simply shows the
impact that a 10-year head start can make on your savings, thanks
to the magic of compounding. You can do the math yourself with
any interest rate or contribution using retirement savings tools you
will find online. A particularly useful website is the Dave Ramsey
Investing Calculator (which was used for the calculations in this
example). 2
Starting to save early is obviously a huge advantage to young
people; however, this means that to build wealth over time, you
have to hold on to your long-term savings. You cannot be dipping
into them frequently, or they simply will not compound over time
in the same way.

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2. Invest for the long haul.
Many people say they want to invest for the long haul, but
temptations get in their way. Everyone wants more stuff: a better
car, a home of their own, or other things like a nice vacation.
Recognizing the need to save for retirement is the first step.
The next tasks in prudent retirement planning include figuring out
when you would like to retire, how much you would like to spend
in retirement, and how much you need to save and invest now to
get there.
How much money do you need to save for retirement? It’s a
simple enough question. But the answer is complicated because
there are so many variables that can shape the answer. Some
variables are known while others are impossible to know, and some
can dramatically change the outcome. Still, planning for any goal as
big and far away as retirement requires some working assumptions,
and an understanding of how they may affect potential outcomes.
To simplify matters, financial advisors use this rule of thumb:
During your working years, you should save enough to have at least
eight times your salary just prior to retirement in order to be
reasonably sure you will not outlive your savings during retirement.
Fidelity Investments (a financial services corporation) further
suggests that by age 35 you should have saved an amount equal to
your current salary. Then you should have three times your salary
by age 45, and five times your salary by age 55. 3
Of course, your life might not fit neatly into such a precise
formula. Your projected savings factor (the amount you need to
contribute) will go down if you start saving earlier, save more, retire
later, spend less in retirement, or generate higher investment
returns. Do the opposite, and the savings factor you require will go
up.
Once you have determined the required level of savings, set
aside a portion of your income and put it in a retirement account.
The most important retirement savings tools are explained below.
You cannot be expected to know everything about these accounts,
but you should explore these options when you begin earning a
living. If you have already begun a career, then the time is now.
Building wealth may be easier than you think!

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Popular Retirement Savings Plans
The most popular ways to save for retirement are 401(k)
accounts and Individual Retirement Accounts (IRA). There are
subtle differences between these kinds of savings vehicles and
between the two most popular kinds of IRAs—traditional and
Roth.
401(k) Plan: This is a plan established by employers in which
eligible employees may make tax-deductible contributions out of
their salary to save for retirement. Employers offering a 401(k) plan
may make matching contributions to the plan on behalf of eligible
employees. Earnings accrue on a tax-deferred basis.
There are limits on the percentage of salary that may be placed
into a 401(k). There are also restrictions on how and when
employees can withdraw these assets, and penalties may apply if the
amount is withdrawn while an employee is under the retirement
age defined by the plan. Plans that allow participants to direct their
own investments provide a core group of investment products
from which participants may choose. Otherwise, professionals
hired by the employer direct and manage the employees'
investments.
403(b) Plan: This plan is very similar to the 401(k), but
designed for employees of certain non-profit and public education
institutions rather than profit-making firms.
Traditional Individual Retirement Account (IRA): This
account allows individuals to direct pre-tax income, up to specific
annual limits, toward investments that can grow tax-deferred.
Contributions to the traditional IRA may be tax-deductible
depending on the taxpayer's income, tax filing status, and other
factors.
When you begin to receive distributions from a traditional
IRA, the payouts are treated as ordinary income and therefore are
taxable. Distributions are required to come out of the account
starting in the year you turn 70 ½. 4

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Roth IRA: This is an individual retirement plan that bears
many similarities to the traditional IRA, but with a different timing
of taxes. The difference is that with a traditional IRA, the
contributions into the plan are tax deductible and therefore there is
a tax savings when you make the contribution. However, taxes
must be paid on the income withdrawn from the plan during
retirement. The situation is just the opposite for a Roth IRA. The
funds paid into a Roth IRA are from income that has already been
taxed, but the funds are permitted to grow tax-free and the
withdrawals during retirement are exempt from taxes. Similar to
other retirement plan accounts, non-qualified distributions from a
Roth IRA may be subject to a penalty for early withdrawals.
Some firms also offer Roth 401(k) plans. These combine the
employer-matching features of a 401(k) with the tax features of a
Roth IRA.
If you take a “qualified” distribution from a Roth IRA, it will
be tax and penalty free. Since qualified distributions from a Roth
IRA are always tax free, some argue that a Roth IRA is more
advantageous than a traditional IRA. The tradeoff concerns the
timing of when the taxes are paid: up-front (Roth IRA) or later
(traditional IRA).
If you expect higher tax rates in the future, you should put
your money in a Roth IRA or Roth 401(k). In contrast, if you
expect lower tax rates during your retirement, you should put your
money in a traditional IRA or 401(k). Exhibit 1 summarizes the
alternative savings and investment plans.

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Exhibit 1: Differences among Retirement Saving Plans
401(k) Roth IRA Traditional
IRA
Tax Retirement Qualified Retirement
Treatment income taxed, retirement income taxed,
but income tax but
contributions free, but no contributions
during working tax advantages during
life have tax from working life
advantages contributions have tax
advantages
Employer of Employer sets Individual sets Individual sets
Individual up this plan up this plan up this plan
Contribution Employee $5.5K/yr for $5.5K/yr for
Limits contribution age 49 or age 49 or
limit of below; below;
$17.5K/yr for $6.5K/yr for $6.5K/yr for
under 50 in age 50 or age 50 or
2013; $23K/yr above in 2013; above in 2013;
for age 50 or limits are total limits are total
above; limits for traditional for traditional
are a total of IRA and Roth IRA and Roth
pre-tax IRA IRA
traditional contributions contributions
401(k) and combined. combined.
Roth 401(k) Cannot Cannot
contributions. contribute contribute
more than more than
annual earned annual earned
income. income.

The Role of Social Security

Social Security can be a valuable supplement to your
retirement savings, but it typically will not provide a comfortable
lifestyle once you have stopped working. Although you may choose
to begin receiving benefits at age 62, you get bigger monthly
benefits by waiting until your full retirement age. If you can wait

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even longer, your monthly benefits go up with each year of waiting
up to age 70. For retirees of normal life expectancy, waiting is a
good deal, because the total benefits collected during retirement
will be greater. Social Security looks like an investment account in
that you pay in during your working years and collect later, but the
government does not actually invest what you pay in. Some
political observers think Social Security will continue indefinitely;
others disagree. Regardless of where one happens to fall in this
debate, benefit formulas may be adjusted to reduce payouts in
future years.

3. Don’t leave money on the table.

Despite people’s best intentions to save and invest regularly,
and despite the incentive provided by employer-provided matching
funds, many employees do not participate in employer-provided
investment plans. For example, although 65 million workers
participate in 401(k) plans, about 35 percent of eligible workers
decline to do so. Moreover, people sometimes borrow money from
401(k)s for emergencies. The opportunity cost of such withdrawals
is high. That money no longer grows, and it must be paid back to
the plan. In 2011 the median size of a 401(k) for people over 55
was only $64,000—not enough for a comfortable living standard
during one’s golden years.
Why is it important to get started early? Let’s use an
investment calculator to address this question. A survey from the
National Association of Colleges and Employers reported that in
2013, the average starting salary of a college graduate was $45,327. 5
Assume that a 22 year old college graduate invests 5 percent of her
starting salary in a 401(k), 403(b), or IRA. Her employer does not
match her contribution. This would be $2,266.25 per year (or
$188.87 per month or $43.58 per week). If this account earns an
annual return of 8 percent and if she does not touch the money
until age 65, it would be an amazing $806,738 close to $1,000,000,
even if she does not get an employer match or save more as her
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income rises. This can easily be computed using the Dave Ramsey
Investing Calculator online. 6 It may seem redundant when we keep
saying “just do it!” (Common Sense Economics), but simply starting a
savings and investment plan is hugely beneficial. If you can just get
started, you can become much wealthier over your lifetime.
The U.S. stock market has had an average annual return of
nearly 11 percent (or about 7 percent, after correcting for
inflation). 7 Of course, these historical numbers do not guarantee
similar results in the future. This is the risk of investing.

4. Diversify your investments.

The key to investing wisely is understanding that there is a
trade-off between risk and return. The greater the risk, the greater
the potential return. Risk is the chance that an investment will earn
less than anticipated or will even lose money. Diversification means
replacing a single risk with a number of smaller risks.
Diversification is the practice of spreading money among different
investments in order to reduce risk. If you choose your group of
investments carefully, you may reduce risk and volatility without
sacrificing much in the way of return.
When deciding how much risk to take on, you should
consider your tolerance for risk and your time horizon. Risk
tolerance is your ability and willingness to lose some or all of your
investment in exchange for potentially greater returns. People who
lie awake at night worrying about their investments have a low risk
tolerance. Thus, they may want to settle for a lower return. On the
other hand, entrepreneurs have a high risk tolerance. They may risk
everything to pursue a new business or investment opportunity.
The amount of risk you are willing to take on also depends on
your time horizon, which is the number of months or years you
plan to keep the investment. The longer your time horizon, the
more risk you can take. Longer-term investments can be volatile.
As noted, the average annual percentage rate of return on stocks is
about 7 percent after correcting for inflation. However, stocks lose
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big—as much as 40 percent—in some years. Even the stocks of
large companies lose money about once out of every three years on
average. 8 If you need to take money out of an investment in a bad
year, you could be in trouble. But if you are invested for the long
term, you can ride out this volatility.
There are many types of investment risk. We’ll look at market
price risk, business risk, inflation, risk, political risk, interest rate
risk, and fraud risk.
• Market price risk is the chance that the price of an
investment will decrease because of changes in supply—or
more likely, changes in demand for that security. Few
investors can consistently predict the ups and downs in
securities markets.
• Business risk is the chance that a business or government
will fail or be less profitable than expected. Because the
federal government can print money, federal debt is
considered safe. The same cannot be said for state or local
government debt or for corporate debt.
• Inflation risk is the possibility that the return on an
investment will be less than inflation, the general rise in the
price of goods and services. For example, federal
government bonds have no business risk, but their annual
rate of return can be less than the annual rate of inflation.
• Political risk is the risk that a government action such as a
change in corporate taxes, regulations, wars, or a change in
trade restrictions will hurt an investment.
• Interest rate risk is particularly relevant for bonds. When
interest rates rise on new bonds, the value of existing
bonds decreases because investors switch their money to
newly issued bonds to receive the higher yields. The
demand for existing bonds decreases and thus the price of
existing bonds falls.

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• Fraud risk is the risk that a seller misrepresents the facts

about an investment. If an investment seems too good to
be true, it probably is. So, if an investment promises a large
gain with little pain, watch out.

Low-Risk Savings Choices

When you save, you want to be able to access your money
quickly and without penalty. While these choices give you safety,
the trade-off is that the interest rates are low:
• Bank and credit union savings accounts: These
accounts are safe and flexible. In 2015, the accounts were
insured by the federal government up to $250,000. 9 You
can withdraw your money at any time without penalty.
The trade-off is the interest rates are low—in recent years
lower than the rate of inflation.
• Certificates of deposit (CDs): These accounts are also
federally insured, but in order to earn higher interest, you
must give up some flexibility. You must tie up your money
for a specific time period ranging from a few months to six
years. If you withdraw your money early, you must pay a
penalty. In recent years the interest rates of CDs have been
low, although they are higher than regular savings
accounts. 10 A good way to improve your interest rate is to
search on a website such as Bankrate.com for the highest
rates. You can open a CD online at any federally insured
bank. You will find that many online banks offer higher
interest rates than the brick-and-mortar banks in your
community.
• Money market mutual funds: Mutual funds pool money
from many customers to make investments. Money market
mutual funds invest their customers’ money in short-term
debt securities such as U.S. Treasury bills and commercial
paper. Corporations sell commercial paper to meet short-

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term debt obligations of less than 270 days. 11 Although
money market mutual funds are not insured by the federal
government, very few people have ever lost money in
them. However, it is not worth the small increased risk
unless money market mutual funds pay higher interest
rates than federally insured savings accounts.

Longer-Term Investments
An investment is designed to grow your money over the
longer term. Stocks and bonds are the most popular investment
vehicles. It is important to understand the differences between the
two.
• Bonds:
A bond is a loan to a government, government
agency, or corporation. The bond pays you interest at a
fixed rate. It has the date when the principal of the loan
will be paid back; this is called the maturity date. Let’s say
you buy a $10,000 corporate loan which pays 5 percent
interest and has a maturity date of 2035. The bond will pay
you $500 a year in interest, and in 2035 you will receive
your original $10,000 back. You do not have to keep the
bond until 2035; you can sell it to anyone who wants to
buy it.
Bonds have two kinds of risk. First, the government
or corporation you lent your money to can fail. The federal
government will not fail, but the trade-off is that its bonds
pay the lowest interest rate. Second, if interest rates go up,
the value of your bond will decline. You can keep the
bond until its maturity and receive the principal, but you
will sacrifice future interest on new investments. On the
other hand, if interest rates decline, the value of your bond
will increase. Hence, it makes sense to buy a long-term
bond when interest rates are high.

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Bond-rating firms such as Standard & Poor’s (S&P)
and Moody’s give bonds safety ratings. Bonds with good
ratings pay lower interest rates than poorly rated bonds. As
the financial upheaval in 2007-2008 illustrate, these ratings
are not always reliable.
• Stocks:
Stocks are riskier than other investments (such as
bonds), but stocks have the highest overall annual rate of
return over the years. As individuals near retirement, they
should begin to shift their investments from stocks to
bonds to reduce risk. When you buy a stock, you become a
part owner of the corporation. You can make money in
two ways. First, as a part owner, you share the profits of
the corporation with the other owners, who are called
shareholders. The profits from stocks are paid out in the
form of dividends, or kept by the corporation to grow it—
or (most often), both. Also, as the value of a corporation
increases, the price of its shares of stock may rise too. The
value of shares of stock is determined by supply and
demand and is affected by multiple events and attitudes. If
the value of your stock goes up, you may want to sell your
shares and get capital gains, which is the difference
between the amount you paid for the stock and the
amount you sold it for. If the value of your stock goes
down and you decide to sell it, the difference in prices is
called a capital loss.

Mutual funds provide a popular vehicle for investment in

both bonds and stocks. A mutual fund obtains a pool of money by
accepting payments from thousands or even millions of people.
The mutual fund company invests this money in financial assets
such as stocks and bonds. By buying small amounts of many
different securities rather than just a few stocks and bonds, mutual

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funds allow people to diversify their investments. If the securities
held by a mutual fund rise in value, all investors will share in that
capital gain. If the stocks held by the mutual fund pay dividends, all
investors will share them. If the bonds pay interest, all investors
will share the interest payments. The amount an investor gains or
loses depends on the number of shares owned. The current share
prices of most mutual funds are published daily.
The question is, which of the more than 18,000 mutual funds
should you buy? There are more mutual funds than stocks. There
are different types of mutual funds: equity funds, bond funds,
sector funds, regional funds, small company funds, energy funds,
international funds, and index funds. There are funds that charge a
sales commission called a load, and there are no-load funds which
do not charge a sales commission. Some funds have large expenses
while others have very low expenses.

Investing Wisely
The process of saving and investing may seem complicated,
frightening, and time consuming to a new investor. In the readings,
videos, and assignments in this module you will see a lot of
information. The good news is that the advice can be summarized
in these three tips:
1. Try to save as much as you can each month. Build your
emergency fund by opening a regular savings account at a
bank or credit union or by opening an account with a
money market mutual fund. Compare the interest rates of
savings accounts and money market mutual funds and go
with an account with the highest rate. As your savings
grow and you feel your emergency fund is sufficient, you
may want to buy a CD or open a mutual fund account to
get a higher rate of return. Money in these accounts will be
for intermediate savings goals.
2. Start to fund your retirement. Find out if your employer
offers a 401(k) or 403(b) plan, and if so, whether your
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employer will match some or all of your contributions.
Take full advantage of the match. If your employer does
not offer a 401(k) or 403(b) plan, open a traditional or
Roth IRA. A Roth IRA is better for young people because
the many years of contributing to it will allow you to
accumulate a large pot of tax-free money. Although you
must pay income taxes on your contributions, you will pay
no taxes on money withdrawn after age 59 ½. 12 If you can
afford it, invest in both a 401(k) and a Roth IRA.
3. Invest for your retirement and other long-term goals with
a broadly based, low-cost, equity index mutual fund. The
managers of index mutual funds buy and sell stocks by the
rules and do not actively manage the funds. Evidence over
the years, summarized in Common Sense Economics, shows
the average annual rate of return on index funds beats
almost all actively managed funds in the long run. Two
types of index funds to consider are funds that track the
Standard & Poor’s 500 stock index (S&P 500 funds), and
funds that track the total stock market (total market index
funds).

When researching index funds, check the funds’ track records

and expenses. Buy index funds with low expenses because every
dollar you pay in expenses is a dollar that is not compounding for
you. A few large funds to look for are:
• Vanguard Total Return Stock Index Fund
• Fidelity Spartan Total Market Index Fund
• T. Rowe Price Total Equity Market Fund
There are many more. The key is to get started as soon as
possible.

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John Morton is the senior program officer for the Arizona Council on
Economic Education. He taught economics for many years at Homewood-
Flossmoor High School in Illinois and was Vice President of program
development for the Council for Economic Education.
Scott Niederjohn is The Charlotte and Walter Kohler Professor of
Economics at Lakeland College in Wisconsin, where he also directs the
Lakeland’s Center for Economic Education. He has published more than 50
journal articles, monographs, reports, and curriculum materials.
Signè Thomas is the Project Director for Common Sense Economics at
the Stavros Center for Economic Education at Florida State University. She is
the founder of Students for America’s Military, Inc. and is frequently
recognized for her philanthropic work with Veterans. She earned a Masters in
Applied Economics at Florida State University.

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1 See footnote 5 of part 4 for the Rule of 70 in Common Sense Economics: Part 4:

Element 8.

2 “Investing Calculator,” Dave Ramsey, accessed June 12, 2015,

http://www.daveramsey.com/blog/investing-calculator/#/entry_form.

3 “How much do you need to retire?,” Fidelity Investments, accessed June 12, 2015,

https://www.fidelity.com/viewpoints/retirement/8X-retirement-savings.

4“IRA FAQs - Distributions (Withdrawals),” IRS, accessed June 12, 2015,

http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-
Distributions-(Withdrawals).

5 “Salary Survey,” National Association of Colleges and Employers, accessed June 12,

2015, https://careers.washington.edu/sites/default/files/all/editors/docs/2013-
september-salary-survey.pdf.

6 “Investing Calculator,” Dave Ramsey, accessed June 12, 2015,

http://www.daveramsey.com/blog/investing-calculator/#/entry_form.

7 “The Callan Periodic Table of Investment Returns,” Callan, accessed June 12,

2015, https://www.callan.com/research/files/989.pdf.
8 Ibid.

9 Geffner, Marcie. “FDIC insures bank deposits to $250,000,” Bankrate, accessed

June 12, 2015, http://www.bankrate.com/finance/savings/fdic-insures-bank-

deposits-to-250-000-1.aspx.

10Lerner, Michele, “CD rates to slowly rise in 2015,” Bankrate, accessed June 12,
2015, http://www.bankrate.com/finance/cd/cd-rates-forecast.aspx.

11“Definition of Commercial Paper,”

http://www.investopedia.com/terms/c/commercialpaper.asp.

12IRA FAQs - Distributions (Withdrawals), accessed June 12, 2015,

http://www.irs.gov/Retirement-Plans/Retirement-Plans-FAQs-regarding-IRAs-
Distributions-(Withdrawals).

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