The past decade was a period where most conventional asset classes experienced lower than historical average returns. This low return environment has discouraged many people to save. “Why bother when I’m not getting much in return” is a comment I’ve heard many times over the past several years. On the surface it seems like it makes sense. But in reality failing to save and to save as soon as you can is one of the biggest mistakes that you can make.
Most people think that investment return is the dominant determinant of future wealth. But in reality the amount of dollars that you save and the time frame involved are powerful influencers as well.
How powerful is saving? A great illustration of this is presented in the article, The Responsible Investor in the December issue of Financial Planning Magazine. The author Craig Israelsen provides hypothetical saving scenarios. In one example, if a 25 year old worker earns $35K per year that increases 3% over the next 40 years and invests 10% of her income, she will end up with $275K by age 65 if there is a 0% investment return over that time. Now if she made 6% on her money, she would have $880K at age 65. Now what happens if the savings level drops? If she only invests 2% of her income, she would have invested $55K and with a 6% rate of return the balance at age 65 would be $176K. To end up with $880K, she would need to more than double the return, with an average annualized rate of 12.4%.
How about time? Isrealsen uses the same base hypothetical above except with an 8% annualized return. In this example, the person will have $1.4 M at age 65. If this person waits twenty years until she is age 45 to start saving, even the contribution percentage is doubled, she will end up with $800K at age 65.
In the end, when you fail to save enough and start saving early it puts an increasing amount of pressure on the need for higher returns. In my opinion, an annualized rate of return of 12.4% is unrealistic to expect, even if it was all in equities and riskier stock sub-sectors. Most people wouldn’t stomach the volatility that an all stock portfolio entails and would flinch during periods of market turmoil, which will further increase the probability of not achieving the target return. The biggest and most important thing to take away from this is that you can control how much you save and how soon you save. Relying on investment returns places your fate on what you can’t control. And depending on fate and luck is a lousy way to plan for the rest of your life.