Earning sufficient returns on your portfolio is an important part of building an adequate nest egg for retirement. We’ve all heard the examples of how even a slight increase in the rate of return, compounded over a long time period, can lead to vast increases in the size of a portfolio. For example, assuming $100 per month is saved and invested over 30 years, the difference in ending wealth is nearly 50% greater at a 7% rate of return compared to 5%. Two percent may not sound like much, but when compounded over 30 years, the difference really adds up.
This return difference highlights the importance of having an investment plan which focuses on factors such as cost minimization, risk management, asset allocation, and generally making good decisions, especially during periods of market turbulence. Returns are very important because the ultimate impact on your portfolio can be profound. This is why many investors place so much time and focus on their investment performance. Yet, it’s important for investors to remember that, while returns are important, another factor has a much greater impact when it comes to building a retirement nest egg. And unfortunately, this factor doesn’t receive nearly the attention it deserves even though it’s something individuals directly control. I’m talking about savings.
A recent article on pensionpartners.com about this subject listed some sobering facts about the current savings crisis in America:
- The aggregate savings rate in America is approximately 5.5%. A few save much more than this and many save little or nothing at all.
- 62% of the population has less than $1,000 in a savings account. Even among those with incomes between $100,000 and $149,000, less than 44% had at least $1,000 in savings.
- 47% of Americans could not afford a $400 emergency. As hard as this is to believe, it does help explain all the pay-day loan and “finance” companies that seem to be all over the place.
- Of working-age families, 43% have no retirement savings and the median retirement balance for a working-age couple is only $5,000.
- 65% of credit card users carry a balance on their cards with an average interest rate of 15%.
These statistics paint a bleak picture. Saving money is difficult enough, but especially when real incomes have stagnated for nearly two decades. Yet, it’s never too late to start. In fact, the later you start, the more the relative importance of savings versus returns becomes.
The following table highlights the increasing value of a portfolio after 30 years of earning 5% assuming increased savings levels. Saving an additional $100 per month results in a portfolio valued at $166,000 and $200 of incremental savings increases the total to nearly $250,000.
In order to build the same portfolio value of approximately $250,000 while only saving $100 per month, the rate of return would have to increase to 10.5%! The surest (and safest) way to increase your nest egg is to increase your savings, not ratchet up the risk level of your portfolio betting on a higher return. Over the long-term, the stock market will likely continue to produce returns like it has in the past, but requiring a high rate of return to reach goals can lead to poor decision making and diminished results. Saving money is difficult but not impossible. Increasing savings is similar to dieting in that it is easy to understand in theory but difficult to implement in practice. We will provide some strategies for increasing savings in a future post.
In conclusion, it makes a lot more sense for investors to focus their time and energy at coming up with ways to increase savings rather than picking the best mutual fund or investing in some fancy alternative strategy. The greatest tool for someone trying to build a retirement portfolio is the rate of savings, not the rate of return, although both are important.