Savings Rate Vs. Rate of Return

A common question I receive as a wealth advisor is, "What investments someone can make to get a big return?"

While Creekmur Wealth Advisors spends a substantial amount of time researching, modeling, and planning investment strategies we do not believe that rate of return is the most important rate to focus on when it comes to investing. We do appreciate seeing a high rate of return and strive to achieve that.

However, the most important rate I would encourage clients to focus on and monitor is their savings rate since it is totally under the investors control and is the largest contributor to your final net worth.

Your savings rate is calculated by taking the total amount of your annual savings and dividing it by your gross or net income. I prefer using gross income as this encourages us to find tax-efficient methods of savings to maximize our savings rate. home-allocation-risk-alignment

A Tale of Two Investors

To illustrate how important the savings rate is look at this example. In both scenarios, the investor earns $50,000 per year. In example A the investor has a savings rate of 5% or $2,500 each year and is receiving an incredible 15% return. After 30 years, Investor A will have $1,249,892 put away.

Example B however shows the investor putting aside 15% of their income and receiving a lower rate of return at 10%. After 30 years this investor will have $1,357,076 put away. That is $100,000 more than example A and with a lower rate of return!

If we project with more conservative numbers such as a 10% rate of return in example A and a 5% rate of return in example B, the investor with a higher savings rate still has around $70,000 more put away after 30 years. It would take an incredible, consistent rate of return to beat a consistent savings rate.

A Lesson From Warren Buffett

Even the best stock pickers have bad years, Warren Buffett for example, lost 48.7% in one year. No matter how good you are at picking investments, your rate of return can never be fully guaranteed. However, you can control your savings rate and effectively build a large nest egg regardless of fluctuating returns.

I recently read an article about the growth of Buffett’s wealth. Shockingly 97% of Buffett’s net worth came after he turned 65. This meant that even though he earned incredible rates of return, the fact that he was consistently saving and growing his investable money is what made the difference over the long-haul.

Compound interest needs a deep base to begin to compound on. By the time Buffett was 30, he had a net worth of $1 million. That meant he did a large amount of savings in his 20s to build his nest egg. If he had a smaller nest egg of $24,000 and maintained his returns, his net worth would be 97% lower than what it is now.

The important lesson we can learn from Buffett is to build a big base as early as possible. You can't control rate of return - so focus on what you can control.