2 min read
Thought experiment: Person A invests $5,000 each year for 20 years and earns 8% annual returns. Person B invests $7,979 each year for 20 years and earns 4% annual returns. Which person will have more after 20 years?
It turns out that they will both have $247k.
Although person A experienced two decades of solid 8% annual returns compared to the mediocre 4% annual returns of person B, the higher savings amount by person B allowed her to make up the difference in investment returns.
The table below further illustrates this point. It shows how different annual investment amounts can lead to the same ending amount after 20 years, despite differences in 4% and 8% annual returns:
The chart below shows another way to visualize these numbers. The size of the circle represents the ending value after 20 years. The-x axis represents the annual rate of return on investment. They y-axis represents the yearly investment.
This little thought experiment proves an important point: A high savings rate can often offset sub-par investment returns. While it’s impossible to predict what type of returns the market will provide in the future, it’s possible to make up for mediocre returns through maintaining a high savings rate.
Note: I was able to find equivalent combinations of savings and investment returns by using this tool: The Equivalent Savings Plan calculator
Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
Although the bulk of his net worth is invested in index funds, his favorite place to invest in individual stocks is M1 Finance, a site that allows you to build a custom portfolio of stocks for free.
His favorite way to save money each month on his recurring bills is by using Trim, a free financial app that negotiates lower cable, internet, and phone bills with any provider on your behalf.
His favorite place to find new personal finance articles to read is Collecting Wisdom, a site that collects the best personal finance articles floating around the web on a daily basis.
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