Chasing returns is a recipe for disaster if you are trying to build wealth through an investment portfolio. I have already described my position on index investing. With this approach you will have average market returns with minimal effort and cost. However, investment returns are not enough. In fact, they are not even the most important piece of the puzzle. Your savings rate is.
A recent article on MarketWatch drew my attention to research by Pension Partners LLC that asked a simple question: Is your personal savings rate or investment rate of return more important?
It is not groundbreaking research, but it is a good reminder of the importance of saving. Pension Partners estimates that the average savings rate for Americans is 5.5%. The study recognizes that many Americans fall short of this. Here are the figures behind this:
- 62% of Americans have less than $1,000 in a savings account. Even at higher income levels of between $100,000 and $149,999, 44% had less than $1,000. See here.
- 66 million Americans have zero dollars saved in an emergency fund. 47% of Americans could not afford an emergency expense of $400. See here.
- 43% of working-age families have no retirement savings at all. The median working-age couple has saved only $5,000 for retirement. 70% of couples have less than $50,000 saved. See here.
- 65% of credit card users carry a balance (don’t pay off their bill every month), paying an average interest rate of over 15%. The average credit card debt for households that carry a balance is $16,048. See here and here.
Those facts are startling. I have talked before about saving for retirement and stressed the importance of doing so. But it is easy to get caught up in a game of returns. If your portfolio returns X% instead of Y%, you are going into retirement stress free. However, if your portfolio returns Y%, retirement will be tight. Don’t bet your retirement on a number you can’t control. Instead, make the right choice and focus on your personal savings rate.
As Queen Cersei says: When you play the game of
thrones retirement, you win or you die run out of money.
Savings rate vs. investment rate of return
It makes sense intuitively that savings rate would be a bigger factor in your overall portfolio than then return on the investment. After all, saving $10,000 per year will grow faster than saving $5,000 per year. The real take away from this research is that each incremental increase in savings rate has a bigger impact on long-term wealth than a corresponding increase in the return rate.
Pension Partners ran the numbers to back this up. They assumed a median household income of $58,000, which after taxes leaves $49,300 of disposable income. Here is what they found:
Saving 1% of your income every year for 30 years with a 10% return would lead to a total portfolio value of $81,096. Saving 5.5% of your income every year for 30 years with a 1% return would lead to a total portfolio of $94,315.
Do you see the difference there? Assuming your long-term return remains positive, you can counter a drop in returns of 9% by increasing your savings rate by just 4%. That, friends, is the power of your savings rate.
Can we all agree that savings rate is THE most important part of our portfolios?
Yes, the rate of return is the second part of the equation, but as mere mortals we have no control over this number. We can do our best to balance risk and reward but predicting the market is a fools game.
If you aren’t saving, now is the best time to start. If you are, but fall into some of those facts and figures above, consider increasing your savings rate. Some of the best advice is to automate your savings each month – a set-it-and-forget-it approach.
Understanding the importance of your savings rate will help you reach your financial goals. To continue to Game of Thrones theme…