I think it’s time to take a look at what makes the most difference to your overall wealth and ability to retire comfortably: Savings rate or Investment return rate.
I have got to be honest with you, when I started researching this article I was a bit skeptical. There are so many articles and books out there about how to increase your investment returns and how different levels of returns impact your overall portfolio. So does this mean that investment returns are the most important?
Not necessarily. Before we jump to any conclusions, let’s stop and take a look at how savings rates affect your portfolio.
The amount of money that you are able to save will vary from person to person depending on their income, lifestyle and frankly, their personality. So, in order to achieve the desired outcomes it is important to set goals for yourself and celebrate the milestones.
One popular framework that people go by is the 50-30-20 principle. Meaning you use 50% of your income for living expenses such as rent, utilities, insurance, etc. 30% of your income goes towards wants, i.e. discretionary spending such as funding hobbies, shopping, eating out, etc. The remaining 20% should go towards repaying debt or ideally; savings!
Now 20% may seem unattainable at times so the key here is consistency. Even if you start off with saving just 1% of your income and increase by 1% each year that would make a difference as opposed to not saving at all. Of course, you might say, you’re not telling me anything I don’t know here.
You’re right, I’m not. I am reminding you though how important it is to save because as you will see further down, the actual amount that you save will have different levels of impact as your rate of savings increases.
Now bear in mind that I am not here to tell you how much you should save. I am here to help you understand the impact different rates of savings will have to your overall investment portfolio.
Let’s assume the scenario where you take home a post tax salary of $40K a year which increases every year to keep up with inflation. You have a 40 year working horizon. The graph below shows it in pounds but you get the idea. The other assumption in this scenario is the rate of return you are making on your investment; ranging from 0% - 5%.
As you can see, the left hand side of the graph shows a scenario where you are saving 5% of your annual income after tax. If the gods of investing shunned you and you made 0% return on your investment, you will have $80K in 40 years’ time. If you made a 5% return, you will have close to $254K.
Now look at the right hand side of the graph where you are saving 30% of your income. Even with no returns, since you are saving 6 times as much you will have $480K in 40 years. If you were to receive a 5% annual return, you’d have about $1.5m in savings. That’s in real terms, folks!
The difference of saving 5% a year at a 5% rate of return vs. saving 6 times as much at the same rate of return is over $1m. Doesn’t that sound substantial to you? Coz it sure does to me.
If you look at it in even more detail, contributing 30% of your income into savings, even with 0% returns will give you a portfolio that is almost twice as large as the one where you’re contributing 5% of your income and still making 5% returns.
Plus, you can control your savings rate, while the investment return rate is outside of your control.
Furthermore, having more savings means you are less dependent on the investment rate of return for your financial goals and when you do get that return rate there is more money to compound on when your own contributions are higher.
So, what about the return rate of your investment?
The return rate of your investment initially does not have as big of an impact as your savings rate does. We illustrated this above.
That doesn’t mean that the return rate is not important, because it is.
It’s just that its importance really starts to show when you have accumulated a significant amount such as let’s say $1 million and you are still making that 5% return. That will be $50K a year that you will be receiving on interest alone. Much more than even your take home salary of $40K that we started with.
If we continue with the scenario where our take home salary after tax is $40K, it continues to increase 5% each year to keep up with inflation and we save 10% of that while making 5% return over the graph below shows you the importance of the savings rate vs. the importance of the return rate.
As you can see in the graph above, savings are much more important as you are starting to invest and only past a certain point do returns start to really take over and make a significant difference to your overall portfolio value.
As you are starting out and up to a significant amount of money invested into your portfolio it is the savings rate that is definitely more important. It is also the thing that is completely under your control as opposed to the oscillation that comes with investment return rates.
Your savings rates matter more as your portfolio is relatively small but as the money accumulated grows significantly, that’s when the rate of return starts to take precedence and it’s not exactly easy for most people to be able to save $50K a year as a 5% return on a $1m portfolio will give you.
If this article ticked your money bone the way it was meant to and you want to see how you can apply this to your own KiwiSaver portfolio, National Capital specializes in creating the right strategy for every Kiwi coming our way so that you also can make the dream of financial freedom a reality. So go ahead, submit our KiwiSaver HealthCheck today and receive a free recommendation.