Wednesday, October 20, 2010

Savings Beat Returns


We're hearing a lot about higher savings rates, which have risen from roughly 1.5% over most of the past a decade ago to the 5% range today[i].  Higher savings rates worry economists who want us to spend our way out of the downturn.  But most financial advisors think that the return to savings habits is a terrific long-term trend.

And it illustrates a secret that financial planners and investment advisors understand all too well: investors (like you) have a lot more control than the professionals (like them) over how fast your portfolio grows.  Seemingly small changes in savings rates can have far more impact on the growth of a retirement portfolio than investment returns.

Let's take a simple example.  Suppose Jonathan has an income of $100,000 per year and manages to save 1% of his total income each year for 20 years--which would have made him a champion saver during the 2000s.  Let's assume Jonathan's salary goes go up 2% a year with the cost of living.  Finally, we'll assume that he's able to earn a very generous 8% yearly return on his portfolio.  (Important caveat: all return assumptions you read here are purely hypothetical and for illustration purposes only, and should not be regarded as an indication of what we or any other advisor might achieve in the unknowable years ahead.  For all we know, the markets may be more or less generous, and they will be so in unpredictable ways.)

The result?  In 20 years, the portfolio would be worth over $93,000.

Now let's suppose that a second person, Joanna, follows today's (much-improved) average savings rate and sets aside 7% of her income each year.  Alas, Joanna experiences a less favorable investment time period, and her portfolio goes up just 4% a year--half of what Jonathan was earning. 

Even so, after 20 years, Joanna's portfolio is worth $373,183.84--more than three times more more in retirement wealth than Jonathan's, even though Jonathan had a much higher rate of return on his portfolio. 

Of course, if Joanna were to save 10% of her income--which is what most financial advisors normally recommend--and if she were to get the same rate of return as the less thrifty person with a 1% savings rate, her terminal wealth would be almost exactly TEN TIMES as much as Jonathan's.

As you know, the numbers are never this tidy, you would never earn the same return each and every year, and most of us don't receive the same salary increase from one year to the next.  But the point, which can be made with much more complicated illustrations, is that, in general, savings rates matter more than rates of return, and seemingly small changes in savings habits can add up dramatically over time. 

No matter what the economists tell you, the higher savings rates we're seeing today are great news for America, one of the few positive changes to come out of the Great Recession of 2008-2009.

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