15 Mar Savings rate vs investment returns
Photo by Joseph Akbrud on Unsplash
So, what’s more important when trying to accumulate a capital sum, the rate of your savings or the investment returns you achieve?
Investors seem to spend an inordinate amount of time chasing investment returns by ether trying to choose the next best investment idea or the fund manager or managers who have ability to beat the market in the future. Whether you believe this adds any value or not (the academic evidence suggests not) investment returns are only part of the answer to being able to meet your objectives.
It is also important to consider when to start saving and how much you can put aside. In fact, particularly in the early years, the amount you save and the length of time you can invest for are just as, if not more, important than the return you achieve on your savings.
Are compound returns really so important? The simple answer is yes but the sooner you start saving and the amount you save, especially in the earlier years, are crucial.
Let’s say that you want to achieve a fund of £500,000 when you are aged 65 because you have calculated that based on your goals £500,000 is your ‘number’ i.e. the amount you need to meet all your lifestyle objectives in retirement, given your other known resources.
If you are able to save £10,000 per year without impacting on your current lifestyle it would take you around 25 years to get to £500,000 assuming you managed to achieve an average annual return on your funds of 5%pa, after costs.
This is interesting in itself, but let’s look at how and when the compound effect of the 5%pa investment return really starts to help you to achieve your goal. The chart below shows how quickly you reach each £100,000 milestone along the way to £500,000 and how much over time is made up of the funds you have saved, and the investment return achieved.
Source: Bloomsbury Wealth
You can see that it takes longer to reach the first c.£100,000 than it takes in future years to add £100,000. The amount you save in the first 10 years has a much greater impact on how quickly your funds grow. This is logical as you are starting from scratch and therefore the impact of the investment return you achieve is much lower as it has less to work with.
The amount you can regularly save has the biggest impact on your progress towards your objectives. Therefore, one of the most important decisions to make when starting to invest is to determine what disposable income you have (income less expenditure) and to consider if there is anything you are prepared to do without or reduce now to be able to spend more later. Effectively you are deciding to defer some expenditure for the future.
The chart also emphasises how investment returns do help and become more important when you have managed to accumulate more savings. The first milestone is always the hardest as it relies more on your ability or willingness to save.
After that and as your funds start to accumulate, the return you achieve plays a greater role in how quickly you reach your goal. Depending on the actual return you achieve, the time when investment returns provide a greater influence than the amount you are saving changes i.e. the higher the return the quicker this occurs.
However, this does not change the fact that as you start to invest for the future the amount you can and are willing to put away has a much greater impact on the time it takes to achieve your goal in the earlier years than investment returns.
It therefore makes sense to spend your time working out what you need to put aside to achieve your goals, given your other assets, future inflows and income, and less on finding the next best investment idea or miracle fund manager. This is also known as having a financial plan based on what you are trying to achieve.
When saving for the future we all need to focus on what we can control i.e. increasing your income and keeping your current expenditure under control so you can put funds aside. Then, having determined how much you need to save (by having a financial plan) and starting to save that amount (by implementing the plan), you need to ensure that you minimise investment fees and have a process for maintaining an asset allocation that is based on your risk tolerance and financial goals.