What matters more: your savings rate or your investing return?
Most would probably say the latter as that gets all the attention. We often hear discussions about how to earn higher returns but savings rates are rarely mentioned.
In reality, though, saving is far more important for the majority of Americans.
Why?
Because most people don’t save very much at all, and without savings you cannot invest. That’s true whether you make $50,000 a year or $500,000 a year. If you spend everything you make, there’s nothing left to invest.
In the U.S. today, the personal savings rate is 5%, calculated as follows:
(personal income less personal outlays and personal current taxes) / (disposable personal income)
The 5%, however, is an aggregate number. Most save far less, with 56% of Americans unable to cover a $1,000 emergency expense with their savings and 54% of credit card users carrying a balance (don’t pay off their bill every month).
I could on and on with these statistics, but they all tell the same story. The vast majority of Americans are saving very little. By extension, they are investing very little. By further extension, the rate of return on their investments is not nearly as important as their savings rate.
Let’s go through some examples to drive this point home. The median household income in the U.S. is roughly $71,000. Assuming an effective tax rate (federal/state/FICA) of 15%, this leaves disposable income of $60,350.
If we assume various savings rates on this $60,350 (1% to 10%) and various returns (1% to 10% annualized), where would this leave the average household after 30 years (for simplicity, we’ll assume a Roth IRA type vehicle with no taxes on gains and assume household income is static over those 30 years)?
The big question: was it more important to earn a higher investment return or to save more?
Let’s take a look…
If a household saved 1% of their disposable income per year and earned a 10% rate of return, they would have a balance of $99,272 after 30 years.
Alternatively, if they saved 10% of their disposable per year and earned only a 1% rate of return, they would have a balance of $209,927 after 30 years.
That’s a 111% higher ending balance for the 10% savers as compared to the 1% savers even though their annualized investment returns were 9% lower.
Note: Table Assumes No Taxes on Investment Gains and Constant Disposable Income of $60,350 per Year
If you’re saving very little today, all of your focus should be on saving more. Why? Because the long-term gains from a higher savings rate will trounce the gains from earning higher returns.
For instance, if a household only saved 1% per year and earned a 5% return, after 30 years they would have $40,096. Earning a 6% return would bump that up to $47,712, a 19% increase.
By comparison, if their returns stayed at 5% but they were able to save 1% more per year (2% savings rate), they would be left with $80,192 after 30 years. That’s a 100% increase in the ending balance through saving 1% more versus a 19% increase from earning a 1% higher return.
Clearly, savings seems to trump investing returns for the average American household. And this is great news, for saving more is something you actually can control, whereas earning a higher rate of return is infinitesimally more difficult.
That’s not to say that saving more is easy. Far from it, especially when the median household income has struggled to keep pace with inflation in recent decades. It takes discipline, hard work, and saying no to a lot of things you may want but don’t necessarily need.
At first, it may seem like the sacrifice is all for nothing as your balance is increasing at a snails pace. But with the passage of time the rewards will become clear, as the magic of compounding takes hold.
Which is why when young people ask me about investing, I tell them to first think about saving. That starts with eliminating high interest rate credit card debt (the average rate today is nearly 20%), which is the best investment you can make. After that, it extends to building an emergency fund (3-6 months of living expenses) that can get you through hard times, without which you will never sleep well at night.
When you accomplish these goals, you are ready to start thinking about investing. But when you do, don’t obsess over returns. For a diversified investor, returns will be what they’ll be; the best you can do is find a portfolio you can stick with and not let your emotions get in the way. A far better use of your time and energy is to focus on what you can control: moving forward in your career, living within your means, and saving more.
To sign up for my free newsletter, click here.
Disclaimer: All information provided is for educational purposes only and does not constitute investment, legal or tax advice, or an offer to buy or sell any security. For our full disclosures, click here.
