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Suppose you invest $10,000 in the stock market in a given year and earn a 7% return on your investment.
At the end of the year, you have your initial $10,000 plus $700 in investment returns for a total of $10,700.
This means 93% ($10,000 / $10,700) of your net worth growth came from savings and only 7% ($700 / $10,700) came from investment returns.
Suppose the next year you invest another $10,000 and again earn a 7% return.
This year you would earn $1,449 (($10,700 + $10,000) * 7%) from investment returns.
This means 87% ($10,000 / $11,449) of your net worth growth came from savings and 13% ($1,449 / $11,449) came from investment returns.
If we keep doing these calculations each year, we’ll find that investment returns account for more and more of yearly net worth increases as time goes on:
In year 1, investment returns only account for 7% of net worth growth.
In year 2 they account for 13% of net worth growth.
Then 18% in year 3…
Notice how it takes about 11 years for investment returns to account for more yearly net worth growth than savings:
After that point, investment returns become the primary force that pulls net worth higher.
Here’s another way to view these numbers:
It turns out that no matter how much you save each year, these numbers hold true. For example, suppose you saved $20,000 consistently each year instead of $10,000:
Only the net worth numbers change. The percentages stay the same.
But what if you earn less than 7% annual returns on your investments? Suppose you save $10k each year again but instead earn 5% annual returns:
We see a similar pattern: Investment returns slowly begin to account for more net worth growth over time, but in this scenario it takes about 15 years for returns to become more important than savings.
This brings up an interesting question: How long does it take for investment returns to overtake savings for different annual return amounts?
This table reveals the answer:
This table assumes you consistently save the same amount each year.
The lower your annual investment returns, the longer it takes for returns to overtake savings. Even with a fairly high 8% annual return, it takes a decade for investment returns to become more important than savings. This illustrates just how important savings are in the beginning of your net worth journey.
Keep in mind that for this analysis we assumed you invested the same amount each year. It’s likely that as you get older, your yearly income will increase and you’ll be able to save more each year.
To see how increased savings impact these numbers, feel free to download the Excel spreadsheet below that allows you to modify the annual savings, annual savings increase, and annual investment returns:
Download Spreadsheet: savings_vs_returns
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 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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