If your primary focus when it comes to investing is how to find a better strategy with a better return, you’re doing it wrong. The truth is that until you’ve built up a sizable portfolio, your investment return, surprisingly, doesn’t matter that much.
What really matters is your savings rate. It may not be sexy, but no amount of return can make up for not saving enough. You don’t have to take my word for it. Let’s look at a simple example.
Meet Jim and Olivia
Jim and Olivia are both 35. They both make $100,000 per year, have $30,000 in retirement savings, and want to retire at 65 with $2,000,000.
Jim takes the exciting approach of trying to maximize his investment return, and it turns out he’s really good at it! He’s able to earn a 12% return year after year, well above current market expectations.
Olivia’s approach isn’t quite as exciting. She goes the tried-and-true route of choosing low-cost index funds, which earn her a steady 7% return per year.
But there’s one other difference.Because Jim is so focused on his investment strategy, he never finds the time to save more than $3,000 per year. So even with his other-worldly (and, frankly, unlikely) returns, he only ends up with just over $1.6 million. That’s $400,000 short of his goal.
On the other hand, Olivia is a savings rockstar. She carves out enough room in her budget to save 20% of her income, or $20,000 per year. And even with her average returns she ends up with over $2.1 million.
By focusing on saving instead of returns, Olivia met her retirement goal and ended up with $500,000 more than Jim.
When Do Returns Start to Matter?
Wade Pfau, one of the leading retirement researchers, has shown that for the first DECADE of your investment life your annual return has less than a 1% impact on the success or failure of your retirement goal.
In other words, it’s a long time before your returns really start to have an impact on your final outcome. It’s your savings rate that matters most. So when do your returns become more important? Here’s a simple formula you can use to figure it out.
Let’s assume that a reasonable savings goal is 15% of your annual income. And let’s also assume that you will get a 7% investment return per year.
With those assumptions, the amount you save each year will be greater than the amount you earn from returns until your investment portfolio is 2.14 times greater than your annual income (15% divided by 7%). If you earn $100,000, that means that the amount you save every year will have a bigger impact than the amount you earn in returns until your investment portfolio reaches $214,000.
Beyond following some simple rules and creating a “good enough” investment plan, your returns are largely out of your control. And the impact of getting better returns would be relatively small anyways. On the other hand, the amount you save is not only directly in your control but it has a BIG impact on whether you reach your retirement goal.
Bottom line: if you want to jump start your retirement savings, stop worrying about your returns and start saving more money.