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If you are a nerd like me, you may wonder which is better– a higher personal savings rate or a higher investment rate of return.
I use to think that it was more important to concentrate on the investment rate. I thought if I could beat the market, I would unlock immense wealth along the way.
When you flip on a channel like CNBC, you hear about how to maximize the highest return on your investments. You can’t go a day without hearing about what Warren Buffett is up to to or how Peter Lynch has unlocked certain investment secrets.
These investment pundits regularly summarize the market’s behavior. They also predict where the market may be going and what we should do next. I use to hang on every word, hoping that it would provide the edge that I needed to get ahead.
If you only listen to these pundits, you might concentrate exclusively on investments. You rarely hear these people talk about saving money. However, you would be mistaken to singularly focus on your investment returns.
Why is that?
“Annual income twenty pounds, annual expenditure nineteen six, result happiness. Annual income twenty pounds, annual expenditure twenty pound ought and six, result misery.” – from David Copperfield, by Charles Dickens
If you don’t save anything, you won’t have any money to invest anyway. It doesn’t matter if you make $30,000 or if you make $300,000.
Studies have shown that over time, consistently saving is much more likely to pay off compared to complicated investment strategies, such as timing the market. As I mentioned in “How the U.S. Compares to the World with Savings Rates”, the personal savings rate in the U.S. is low, very low. Unfortunately, in October 2017, the downward trend continued, with an average savings rate of just 3.2%.
US Personal Savings Rate
Source: Trading Economics
A 3.2% savings rate means that the average American spends 96.8% of their personal income. The average 401(k) match is 3%. Therefore, the average American with a 401(k) may only save 0.2% of their income, outside of their 401(k).
A 0.2% saving rate? Ouch. That basically equates to saving your pocket change. That’s horrible.
On top of that, this is an aggregate number. For every person who is making great strides towards FIRE and saving 60-70% of their income, there are people who hold negative savings rates. These people are deep in debt.
Fluctuating Personal Savings Rate
Below, you can see that from 1960 to 2016, the personal savings rate has fluctuated wildly over the years, from a high of nearly 13% to a low of just under 3%. The main take-away that I see from this chart is that when things are going well, Americans tend to stop saving. On the other hand, when the economy goes into a recession, people are more likely to start saving.
Why people stop saving during the good times is beyond me. It just seems silly to me.
Savings Rate vs Investment Rate of Return
In 2016, the median income in the U.S was $59,039. If you pay 25% in taxes, that would leave you with roughly 75% of your income. According to Tax Form Calculator, that would leave you with roughly $44,000 in income after accounting for taxes (for California residents).
Now, let’s see how various savings rates on $44,000 (1% – 6%) would affect returns over 30 years. Then, let’s compare that to the various investment rate of returns (1% – 10% annualized).
For those in the FIRE community, the results may not surprise you.
Based on the chart below, if you save 1% annually and receive the average rate of return of 8% from the stock market, you should return virtually the same amount as if you had saved with the national average savings rate of 3.2% and earned a 1% rate of return.
Increasing Your Savings Rate
Interestingly enough, if you increase your savings rate by just 2%, while still having an investment rate of return of 1%, you would beat the investment return of someone with a 1% annual savings rate, who was able to increase their investment return to 10%.
|Savings Rate (Per Year) Value After 30 Years|
|Annual Rate||1% ($440)||2% ($880)||3% ($1,320)||3.2% ($1,408)||4% ($1,760)||5% (2,200)||6% (2,640)|
According to David A. Schneider, CFP professional and principal at Schneider Wealth Strategies in New York City,
“An average saver will do better than a great investor who doesn’t save. Let’s say you are in the rare group that can outperform (the stock market by) 2 percentage points per year — few can do that. But you can’t accumulate as much as someone who was more of an average investor but saved in a disciplined and consistent way.”
Savings > Investing Returns
Therefore, savings clearly trumps investing returns for the average American. This is great news, since we have much more control over savings. Trying to beat the stock market is much, much harder to do. Even professional traders have a hard time doing this.
“The only thing that you can control is the amount of capital you invest. Even during periods of low market returns, the frequent addition of investment capital can have a lasting effect,” says Bob Stammers, CFA, director of investor education for the CFA Institute. “Consistently adding capital to your portfolio, as well as the long-term returns earned on that capital, is an excellent way to steadily move toward your overall financial goals.”
I think that this sketch by Carl Richards, author of the book The Behavior Gap, perfectly illustrates the point that I’m try to make.
You may be wondering if I am considering how the market has been doing recently. Yes, it has been on fire. 10% is nothing when the stock market has been exceeding that over the last eight years.
“The fact that we had large returns over the past eight years was to make up for a 40% drop in the stock market during the financial crisis of 2008,” says Blair Duquesnay, chief investment officer at ThirtyNorth Investments. “It is unlikely the next 10 years will look like the past 10 years.”
I’m not saying that saving more money is easy. However, when people ask me for stock market tips, I always encourage them to first look at their savings rate. The time that it takes to increase your savings rate is much less than the time involved with trying to beat the stock market’s returns.