3 min read
Fun fact: Someone who invests $20,000 per year at a 1% interest rate will have $103,040 after 5 years. Someone who invests $15,343 at a 10% interest rate will also have (roughly) $103,040 after 5 years.
Another fun fact: Someone who invests $40,000 per year at a 1% interest rate will have $422k after 10 years. Someone who invests $24,110 at a 10% interest rate will also have $422k after 10 years.
These two examples illustrate an important concept in personal finance: a high level of savings can help offset poor investment returns while stellar investment returns can help offset a low level of savings.
This is why person A who saves $40k and earns pathetic 1% annual returns can accumulate the same amount of money as person B who saves about $24k and earns incredible 10% annual returns.
To further explore this idea, yesterday I shared a tool that shows how different levels of savings and investment returns can lead to the same ending amount during equivalent time horizons:
Using this tool, you can change the amount invested, the annual interest rate, and the time horizon on two different savings plans to see how two different levels of savings and investment returns can lead to the same ending amounts.
Savings vs. Investment Returns
In the finance world, we have a tendency to glorify investing and ignore good ‘ol fashioned saving. Part of the reason is because investing sounds exciting.
With investing, there are so many levers you can pull and dials you can tweak. You can change your asset allocation, your re-balancing schedule, and your investment vehicles. You can buy, sell, and track investments online at any hour of the day.
Saving money, on the other hand, just seems so boring. It’s more exciting to see your net worth grow by $10 thanks to investment returns instead of depositing $10 in your savings account from not buying that burrito.
But the truth is, the amount of money you save is often more important than the investment returns you earn, especially when you’re just starting out.
Going back to the first example, why is it that someone who saves $20k earning 1% returns can save $100k just as fast as someone saving about $15k earning incredible 10% returns? It’s because investment returns just don’t matter much when saving your first $100k.
Consider this chart, which shows that if you can save more than a few hundred bucks per month, different investment returns hardly impact the time it takes to save your first $100k:
Here’s another useful tool that compares savings vs. investment returns. Using this tool, we can see that someone who saves $15k earning 10% returns for five years will accumulate just over $100k. Despite their incredible 10% returns, their raw savings still account for the bulk (74%) of their net worth:
The person who saves $20k per year earning a 1% interest rate will have a whopping 97% of their net worth comprised of savings:
Focus On What You Can Control
Your net worth is simply a sum of your savings and your investment returns. It’s obviously more fun to see your net worth grow as a result of investment gains as opposed to saving a huge chunk of your paycheck, but at the end of the day they both help you achieve a common goal.
It’s important to remember that investment returns are mostly outside of your control, while your savings is entirely within your control. Sure, you can practice smart investing through index fund investing, re-balancing, and dollar-cost averaging, but ultimately you can’t control stock market returns.
You can, however, control how much of your income you save. You can pursue side hustles to increase earnings. You can practice living with less to reduce your spending. These variables are within your control.
By increasing how much you save, you give yourself the ability to offset poor investment returns. If your investments do perform well over time, that’s just icing on the cake.
Be sure to check out both of these interactive tools to see exactly how savings and investment returns impact net worth:
Thanks for reading 🙂
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