We all need to plan for our financial future and ultimately retirement. Fortunately, engineers starting out today have better investment opportunities than ever before. Unfortunately, however, the value and benefits of regular investment may be the fur thest thing from a new graduate's mind.
This article will show you how to apply the principles of engineering economics to your personal investments. These principles are just as applicable to your personal finances as they are for your employer's capital projects. (Engineering economics is a required topic on both parts of the exam for Professional Engineering licensure.)
The goal of this article is not to give statistics, but rather to show the techniques involved so you can apply them to your own personal financial plan. It will examine the question: "How much do I need to invest to accumulate a million dollars?" Does this sound interesting? Or impossible! How can you invest your way to $1,000,000 making, $40,000 a year? The answer lies in systematic investment, and the goal may take less time than you think.
When it comes to personal finances, we tend to concentrate only on the short-term. Often, we approach the future as a complete unknown. "How can I predict the future'?" you might ask. My advice is to approach it like an engineering problem: First, make some basic assumptions, and then apply the basic formulas of engineering economics to solve the problem. We can account for uncertainties just as in other engineering systems with good planning and controls.
According to the National Association of Colleges and Employers, as of March 1995, the average starting salary for chemical engineers is $39,833. Let's use this as a starting point. Let's assume a constant 4.6% annual rate of inflation. We'll use your employer's 401(k) plan for your investments, and invest in a fund that buys the Standard & Poor's 500, which averages about 15% growth each year (which we'll also treat as a constant). Say the plan allows you to contribute up to 16% of your pay, and matches the first 3% dol-lar-for-dollar, for a total maximum investment of 19% of your salary. We'll also assume that your salary just keeps up with inflation, with no promotions or merit increases.
The basic equations for the calculations are summarized in Table 1. These can easily be programmed into a spreadsheet, which I recommend you do to explore the various "what-ifs" relevant to your own situation.
Use the future worth equation, F = P(1 + i)n, to calculate the value of the 401(k) account each year at year-end. Note that each year's contributions average about half the earnings because they're spread over the year. Table 2 shows the results of the investment strategy. You may need to study Table 2 until you understand it, but once you do, you'll see how to make it more meaningful for your own situation.
Notice that the contributions you make when you are young really grow, whereas the later contributions have less impact on the net worth. This shows the clear message – invest when you're young! Investment is hardly the first thing on the minds of engineers starting their careers, but by investing young, many doors are opened in your future.
Notice that by age 38 there's more investment income than salary income. This is the point at which you are financially independent. This is also where you'll really see the dramatic effect of compounding. In this example, the investments grow to over a million dollars by age 42, after working only 19 years and drawing a total of $1,243,228 in salary.
What if you wait until later to begin investing? If you wait until age 30 to invest at this level, you'll have to invest until you're 47 before you have a million (future) dollars. If you only invest between ages 22 and 30, you'll only have to wait until you're 45. If you wait until age 40, you'll be 54 before you have a million (future) dollars.
Of course, a million dollars in 20 years won't buy as much as it does now. Use the present worth equation to calculate its worth in today's dollars:
To convert a million current dollars into future dollars, use the future worth equation:
Table 2 shows that you'll reach this point at age 47. So you'd have to work 25 years or so to get a million in today's dollars. But what's five more years of work when you're already a millionaire?
You'll have to set your own goals, but let's look some more at the goal of a million dollars in the future.
For one thing, we're all battered with thousands of investment options. Some of them are "safe" and some have some "risk." There's some confusion over the word risk in investments. It's most often used to describe a volatile investment (one with a widely fluctuating market value). It can also describe one that is in danger of collapse, which is a risk we don't need.
Volatile investments such as stock portfolios have proven themselves historically as the best performers and are often the preferred long-term investment. Table 3 shows the historical averages for several classes of investments.
Table 4 illustrates the effects of investing varying percentages of your salary at different long-term earning rates. Use Table 4 to compare the long-term growth potential of various investments against their risk. Notice also the net effect of "low risk" investments – they actually risk your financial future by barely keeping up with inflation.
One way to combine constant inflation (e) and constant growth (i) is to use the relationship (1):
Using this corrected rate can help you plan retirement income (withdrawals from the retirement account) that will keep up with inflation. Let's say you've got $500,000 for retirement. This time we'll use an investment earning 12%, still with 4.6% inflation. Don't just subtract inflation from earnings; rather, apply the corrected interest rate instead:
Using the corrected rate will allow the principal to grow with inflation while providing an income level that will also rise with inflation.
What if you can't afford to invest 16% of your income? How much you save is entirely up to you. You'll have to plan your own finances. My goal in writing this article is just to make you aware of the possibilities, and to encourage you to make your own plan.
You may choose to make a few sacrifices now to be able to invest more for the future. You have to set your own goals for life.
Another problem is uncertainty. For example, the stock market fluctuates by the minute – how can you predict the future earning power of an investment? The simplest way is to use a long-term average of past performance, just as you might approach an engineering problem. Mutual funds normally report performance in terms of 1-yr and 5-yr averages. They are easier to track than stocks, and one fund can give you a diversified portfolio. Several good investment books are listed in the further reading section.
How often should you invest? Dollar cost averaging is one of the most recommended strategies for investing money. It means investing at regular intervals, buying when prices are high and low. This approach evens out the swings in stock prices and also eliminates the need to "time the market" and "buy low and sell high." Most investment guides include worked examples illustrating the benefits of dollar cost averaging. Using a 401(k) plan with payroll deductions, with each paycheck you can automatically use this time-honored method for purchasing investments.
Don't lock into a plan. Instead, experts often recommend updating the plan every year to see if it meets your long-term goals. And if your plan does not stay on track, like any engineering system, it may need to be revised, updated, even overhauled.
One thing is for certain: if you have a plan, you have taken a proactive approach to your financial future. CEP
This article is intended to teach the fundamentals of engineering economics. While the principles presented here have been checked with sources believed to be reliable, the estimates and opinions are merely instructional, and not intended to provide investment advice. Please consult a qualified financial planner for investment advice.