So today I want to talk about and show you just how important rate of savings is AND how it can help provide flexibility when it comes to investing.
FACT — ALL THINGS BEING EQUAL, A HIGHER PERSONAL RATE OF SAVINGS WILL ALWAYS OUTPERFORM A LOWER RATE OF SAVINGS.
But what if we didn’t make all things equal? Will it still work? You bet!
Here’s the parameters:
Couple A has a combined household income of $300,000 and is saving 5% of their gross income, or $15,000 per year
Couple B also has a combined household income of $300,000 and is saving 20% of their gross income, or $60,000 per year
For today’s convo, we don’t care where they’re saving it (401k, IRA, etc). We’re simply looking at the rate of return vs rate of savings.
Now Couple A is socking away their $15,000 and they’re going to have a very strong run of investment success. In fact, they’re going to earn 10% for TWENTY consecutive years. Every year, they seem to find the exact investment that has a phenomenal rate of return. And of course, their hypothetical 10% rate of return is net of fees and net of taxes. It’s truly a magical run. Even Peter Lynch would be envious.
We see at the end of our 20 year study period they have just shy of $950,000. Nothing to sneeze at but likely not enough to maintain a similar lifestyle in retirement.
Couple B on the other hand is saving at a much higher clip…20% of their gross income. And regardless of their rate of return, they’ll always end up with more money than Couple A. That’s a bold prediction, huh? I might know a few things.
First example, Couple B earns 7% which is roughly what the S&P 500 index returned over the past 20 years. And we can see after 20 years we have just more than $2.6m. 7% isn’t that far off from 10% and Couple B is saving far more than Couple A. Let’s make things a little more interesting.
This time around Couple B earns 5%. According to DALBAR’s 2017 Study of Investor Behavior, this is roughly what the Average Equity Fund Investor earned so it should be a better reflection of real rates of return. The graphic shows a far better result with just more than $2m at the end of 20 years and more than double what Couple A has. And again, this should be result but Couple B has achieved it with half the rate of Couple A. Interesting.
Now let’s say Couple B simply wanted to invest their savings and earned 3% for the next 20 years. Maybe they invested in a bond fund of some type. Let’s also assume interest rates remain low for the entire study period. Hey, it could happen!
Drum roll and as we see below, just north of $1,640,000.
Still better than Couple A.
I’ll save you the graphic if we dropped it down to 2% which is roughly what a bank CD is paying these days. 2% for 20 years would have resulted in nearly $1.475m for Couple B.
Still better than Couple A.
Now Couple B is really feeling risk averse and they decide to just park their cash in a bank account that pays them 1% for the next 20 years. Basically a money market account today, right? And after 20 years they still have more money than Couple A with roughly $1.325m.
For our last example I won’t even show you the graphic because Couple B is going to earn 0% on their money. You heard me correctly.
They’re literally going to take 20% of their paycheck from the bank in cash, stuff it in a coffee can, and bury it in their backyard. They’re going to do that every month for the next 20 years (and we pray they keep good records…lol!).
Say it with me now…still better than Couple A.
This last one always astounds me.
Even with a 0% rate of return, a 20% rate of savings will still outperform a 10% rate of return with a 5% rate of savings. And it will yield roughly 20% more money!
So now that we’ve seen the data behind it, some things to expand upon.
- When your rate of savings is lower, your chances of financial success are lower
- When your rate of savings is lower, you’re essentially forced into taking more risk (read: chasing higher rates of return)
- When you’re chasing higher rates of return, you are not relying on financial factors in your control
The markets don’t care what rate of return your financial plan projections require to make it work. As my mom used to say, you get what you get and you don’t get upset. That’s the market in parent speak! Remember our financial planning formula above? If our financial plan requires a 7% rate of return and we only get 6% then we fall short of our projection. The only way to make up the shortfall is to add in one of the other areas: save more money, work longer, or get a higher rate of return moving forward. Or we could retire on less. Your call.
Couple A achieved a very, very strong (lucky!) rate of return for 20 consecutive years. The amount of risk we have to assume for that rate of return is also very high. I’ll spare you the financial advisor geek speak but the standard deviation on that is way up there. Think about it for a second:
10% rate of return. Net of fees. Net of taxes. For TWENTY. CONSECUTIVE. YEARS.
Oh, and they never had a down year. Even with the very lucky market timing and stock picking, Couple A fell well short of Couple B in all comparisons.
On the flip side, the opposite is true when your rate of savings is higher:
- chances of financial success increase,
- increased risk is an option not a requirement
- we’re focusing on a financial factor (rate of savings) we can control
Couple B, if they were so inclined, had options. They could chase the risk and try for the home run like Couple A (which for those curious would have netted them nearly $3.8m after 20 years). Or they could bury their money like doomsday hoarders. Or they could have done anything in between and STILL had a better financial outcome than Couple A. And by focusing on rate of savings over rate of return, I imagine Couple B would have better odds of investing success. Simply knowing their increased rate of savings has them positioned for long term financial security might allow them to behave better around their investments, decrease worries around market declines, etc. Not a guarantee, but just a hunch.
So here’s what we know:
- RATE OF SAVINGS IS A FINANCIAL FACTOR WE CAN CONTROL. WE DECIDE (READ: CONTROL) HOW MUCH OF OUR MONEY WE WANT TO SAVE.
- HIGHER RATES OF SAVING BETTER ALLOW US, IF WE CHOOSE, TO REDUCE RISK WHEN IT COMES TO OUR INVESTMENTS AND STILL ACHIEVE FAVORABLE OUTCOMES.
- RATE OF RETURN IS NOT A FINANCIAL FACTOR WE CAN CONTROL. WE DO NOT DECIDE THE RATE OF RETURN OUR MONEY RECEIVES WHEN WE INVEST IN THE MARKET. (NOTE: SOME PEOPLE WILL TELL YOU THEY CAN DO THIS. THEY PROBABLY ALSO HAVE BEACHFRONT PROPERTY THEY WANT TO SELL YOU, TOO.)
I know I harp on this but it’s something I really and truly believe in:
Focus on the factors you can control
*Hypothetical examples are not intended to suggest a particular course of action or represent the performance of any particular financial product or security.