Savings Rate vs. Investment Return: Which is more important in wealth creation?

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Savings Rate vs. Investment Return: Which is more important in wealth creation?

Most people have heard the advice to save early.  We wrote a blog in 2014 titled Importance of Investing at a Young Age and Best Practices.  In addition to emphasizing the importance of saving early, it also answers the common question of “where” to invest your savings.  When it comes to investing though, most individual investors enjoy talking about their investment return especially when things are going well.  It is easy to share a story over a few drinks with friends at the party about the home run stock you bought.  When it comes to building wealth at a young age though, the savings rate is actually a much more impactful number.

There are two types of wealth every individual possess through life which collectively equal your total economic wealth.  The first is human capital (“HC”) and the second is financial capital (“FC”).  HC + FC = Total Economic Wealth.  The value of your HC is the sum of your earnings potential throughout life.  This will decrease as you age and approaches zero the closer you get to retirement.  The second is FC which consists of all your financial wealth.  Theoretically, this starts at zero and hopefully increases as you save and invest.  As you get to retirement, FC can decrease, increase or stay relatively flat depending on the amount of money in relation to your total FC you are taking out each year.  Below is a good visual of the value of an individual’s HC and FC over their lifetime.

Source: https://www.morningstar.com.au/smsf/article/link-wealth-creation/7037?q=printm

The reason the savings rate is more impactful at an early age is simply because your HC is a much higher value at an early age in comparison to your FC.  For example, a married couple who are both 25 with annual gross earnings of $150,000 per year has HC equal to $4,500,000.  A dedicated savings rate of 5% on $4,500,000 is going to be a much higher value than any return on your FC at age 25 simply because the base is going to be that much lower.  To drive this point further, below is a chart which shows the same married couple with $150,000 in gross earnings and shows a 30-year future value depending on different scenarios between savings rates and investment returns.

As an example of the disparity and impact between savings rate and investment returns, take the 1% savings rate and 10% annual return scenario in the top right hand corner of the chart.  In 30 years, you end up with $246,741.  In comparison, at a 5% savings rate you need a whopping 1% return to achieve a higher future value of $260,887.

The other benefit of concentrating on your savings rate is that it’s a factor you can actually control whereas you can’t control market returns.  As a good habit, you should have an idea of what your savings rate is.  Small increases in your savings rate can make a large impact on your future retirement assets over time.  We don’t want to down play investment returns but in your early years, the savings rate does have a larger impact.  As your FC grows and your HC declines throughout your life, the benefits of savings rates decreases and the benefits of the investment return increases, but early on, concentrate on your savings.  It’s more dependable and makes a larger impact on your future right now.

 

 

 

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