Why Your Savings Rate is More Important Than Your Investment Return

When you’re starting out investing, it can be intimidating to know what to do. Where do you start? What stocks should you buy? Should you even buy stocks? What about ETFs or mutual funds? Savings accounts? Paying off debt?

I’m here to provide you with some much needed relief: it doesn’t matter all that much what you do. It doesn’t. Whether you make 10% per year or 1% early on in your investment life is not as important as much as how much you save.

Frugal Frank vs. Savvy Sarah

Consider two 25-year-old investors. Both make $50,000 per year — the median household income in the United States.

Savvy Sarah is a smart investor and an average saver. She manages to put away $833 per month and earn a compounded annual return of 7% per year. That’s $10,000 per year or about 20% of her after-tax income.

Frugal Frank is a terrible investor, but an above-average saver. He manages to save an extra 5% of income — $1,250 per month. That’s $15,000 per year or 30% of his after-tax income. But, he only earns the 1.8% per year offered by his local bank.

After 10 years, who has more money?

Savvy Sarah has roughly $148,000 compared to $166,000 for Frugal Frank. The better saver ended up with quite a bit more money — despite earning 75% less per year on investments.

Conventional wisdom might suggest the higher compound interest leads to greater results. That’s true at some point in life. But it takes time for investment results to matter more than savings rates.

After the portfolios grow larger, Sarah’s investment returns start to matter quite a bit more. Over the next 10 years, Sarah’s portfolio grows about $90,000 larger than Franks despite her saving $50,000 less. She ends year #20 at $439,000 compared to Frank’s $364,000 portfolio.

What does this mean for you? Three things:

Your % savings rate is most important when you’re starting out.

If you want to be a multi-millionaire one day, you can’t live like one now. The more you look rich now, the less rich you’ll actually be in 30 years.

Focus on increasing your savings rate as high as possible.  To calculate, take the dollar amount you save divided by what you make after taxes.

It looks like this:

401k retirement account contributions
+ Traditional IRA or Roth IRA contributions
+ early debt repayment
+ extra going to bank savings account
= total savings per year

Divide that number by your take-home income after taxes.  To calculate, that you can multiply your monthly paycheck by 12.

Monthly paycheck from employer (after taxes) x 12
+ Any other income received (business income, etc.) after tax
= Total income

How much should you save? Conventional wisdom says save 15% of your paycheck. That’s weak.

If you were born after 1980, you can’t rely on the government to bail you out when you’re wrinkled and old. Social Security may not be around — or may be a shell of its current self. You have to take your future into your own hands.

The best place to start? Save more than 15%. Far more. Shoot for at least 30%. If you want to reach financial independence sooner, aim for 50%.

Don’t worry if you can’t save 15% right now. For the next 12 months, try to save 1% more than you did last month. That’s it. 1%.

That shouldn’t be difficult. If you’re earning $50,000 per year — that’s only $42 per month. Cut the cable bill and switch to Netflix.

Next month, find another $42 per month to save.

When you run out of cuts to make, start selling some of your old junk on Craigslist or Facebook Marketplace.

When you run out of stuff to sell, start looking for ways to make an extra $42 per month. Offer a service. You can make $50 flipping stuff on Facebook Marketplace or Craigslist. Offer some kind of service.

Anything you can do, do it. Get that savings rate as high as you can. That and learning from your investment mistakes should be your top priorities.

After 12 months of cutting spending or increasing income by 1%, you’ll be saving 12%. Keep that momentum going and save as much as possible. It will pay off down the road.

Early investment mistakes are far less costly than later mistakes.

By all accounts, a 1.8% return is a lousy one. A balanced portfolio of stocks and bonds should produce around twice that return. With no effort required. The average stock should produce around 7%.

But even if you are a terrible investor at the beginning, you’re still in fine shape as long as you save aggressively. It’s far better to make mistakes now as opposed to when you’re planning to retire in 5 years. In fact, those mistakes you make now — assuming you learn from them — will make you a better investor. Your results will be much better when it counts.

That’s why you should consider investing in individual stocks. At least for a few years. And at least with a part of your portfolio. Even if you make terrible mistakes — you’ll learn so much more than you would if you dumped money in some funds. That knowledge you gain will be worth far more than whatever returns you gave up.

Your investment returns get more important as your portfolio gets bigger.

If stocks grow 10% and you earn 3% — your investment decisions cost you 7%. If you’ve only got $1,000 to invest — that’s not a big deal. $70. Who cares? When you’ve got a $100,000 portfolio — that 7% represents an opportunity cost of $70,000. And when you hit $1 million, you can take another zero on the end. Ouch.

You have full permission to “play” around in the market. But, when your portfolio reaches $100,000 — it’s time to consider how your investment returns are doing compared to other options. If your returns are falling too far behind, you need to think about making a change.

Bottom Line

Focus on saving as much as you can while you’re young. Whether you invest this in the stock market or use the money to pay off debt doesn’t matter. What return you get doesn’t matter that much, either. What matters most is that you’re doing something constructive for your future.

Make mistakes now and learn from them. You’ll be much better prepared to invest for yourself later in life. If continue to make the same mistakes with $100,000 or more — you should consult with a trusted friend or hire an investment advisor. If they can help you improve returns by more than 1% compared to what you’re doing — it’s worth paying them.

And if you do hire an advisor, your early investment experience will help you decide who’s good and who’s bad. You’ll recognize a good strategy from a bad one.

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Thanks for reading!

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Nathan