I can summarise this post in one sentence. When Starting out, your savings rate is more important than your the rate of return on your investments – but later on when your pile of money is bigger, your investment returns matter far more.
That is it. If you truly understand this statement, you can rapidly build your net worth over time. You can now close this article and be on your merry way. But for those of you who want to understand more and want they dynamics of how this works, read on.
To understand this concept, have a look at the following:
- A 8% return on £1,000 is £80.
- A 8% return on £10,000 is £800.
- A 8% return on £100,000 is £8,000.
This is basically the law of large numbers. The higher your portfolio’s worth, the faster it can grow in dollar or pound terms.
When you are young or just starting out your financial independence journey, you have very little cash to invest. So any returns in nominal or pound terms will be very small at the beginning. The key then is to save more. Saving really the key to building the significant asset base that financial independence requires.
Let’s look at an example to see what I mean
Tom, a teacher, earns £30,000 a year which is slightly above the average UK salary. Tom has his mind set on financial freedom and thus saves and invests £6,000 a year. On this, he’s return is 10% per year.
After the first year, Tom would have net worth of £6,600. That is only a gain of £600.
Even if he is the new Buffet and earns a 20% return per annum, he would only make £1,200 in the first year. It is far easier to save an extra £1,200 than earn returns of 20% per annum.
The impact of the market returns is inconsequential when compared to the wealth building that comes from cutting the fat in your budget and saving an extra amount.
At least in the early years, leveling-up your personal savings rate is going to have a far bigger impact on your net worth than chasing those extra investment returns.
In fact, it’s far easier to save a few extra percentage points of your income than it is to achieve higher rates of return from the stock market. You could struggle for years trying to generate returns that exceed the market… OR you could just forgo a couple fancy purchases and quickly double the number of assets under your control. It’s that simple.
Frugality wins – at least when the portfolio sizes are small.
It is far easier to grow your net worth via higher savings than portfolio returns when you are starting out. Below is an example is an example to demonstrate this point.
In the example above, it would be far wiser for Tom to concentrate on his savings in the early days as this way he can turbocharge his net worth.
Say Tom takes a long hard look at his budget and cuts £4,000 worth of expenses – see how in the save more section – he is now able to save £10,000 a year.
This simple move means that he is already up by 66% per annum. This is a far better return than Buffet, Soros or Lynch can get you.
Again, say Tom earns 10% in investment returns. Below is a table of his returns. You can already see how fast his net worth goes in the early days. But this table serves another purpose – it shows exactly when investment returns matter more than saving. I describe this below.
|Year||Contribution Per Annum||Return Per Year||Net Worth|
Looking at the above, if you invest £10,000 in the stock market and obtain a return of 10%, at the end of the year, you have your initial £10,000 plus £1,000 in investment returns for a total of £11,000.
This means 90% (£10,000 / £11,000) of your net worth growth came from savings and only 10% (£10,00 / £11,000) came from investment returns.
In the second year, you invest another £10,000 and again earn a 10% return. This year you would earn £2,100 ((£11,000 + £10,000) * 10%) from investment returns.
This means 82% (£10,000 / £12,100) of your net worth growth came from savings and 18% (£2,100 / £12,100) came from investment returns.
If you keep doing these calculations, you will see that your investment returns will count for more and more of your net worth over time.
In year 1, investment returns only account for 10% of net worth growth
In year 2 they account for 18% of net worth growth.
Then in year 3, it becomes 25%.
The trend here is clear, savings are important at first. But with time, investment returns take over due to the power of compounding.
Someone who saves and invests £10,000 each year at a 10% interest rate will accumulate £100k in just under 7 years. Out of this £100k, close to 70% of it will be composed purely of savings. The other 30% will be composed of investment returns.
Looking at the second £100,000 (or to reach the £200,000 mark from £100,000), it only takes 3 years and a bit. Out of this second £100k, only 40% of it will be composed purely of savings. The other 60% will be composed of investment returns.
Looking at the third £100,000, it only takes 2 years and a bit. Out of this second £100k, only 25% of it will be composed purely of savings. The other 75% will be composed of investment returns.
With the fourth £100,000, investment returns account for over 80% of the amount.
The trend is clear.
Investment returns start to become more influential as your net worth increases,
The magic mark for me personally is 7 years. It takes 7 years for investment returns to account for more yearly net worth growth than savings. It is from this point that investment returns matter more than savings. This is the point where the gain from investment returns crosses that of the amount of new money being put into the portfolio via savings.
In this case, 7 years is that magic mark after which your portfolio returns matter more than your savings. But the no of years it takes to cross this threshold depends on your rate of return. If you earn 6% per annum, it would take you 12 years. 7% per annum returns would take you 11 years. 8% per annum return would take you 10 years.
If you’re at the beginning of your net worth journey, you should focus on saving as much of your income as possible. Most of your net worth increase in those early years will come from savings, not investment returns.
Once your investment returns begin to overtake your savings, your net worth begins to skyrocket.
So focus on saving hard early on in order to build a solid foundation. After you reach a certain point, investment returns will begin to make life easier.