Savings Rate or Rate of Return? How to Focus Your Attention for Long-Term Financial Success
By: Chris Arnold August 21, 2018
As a young professional, one of the best pieces of advice I received was to save and invest 15% of my salary for my future.
At the time, when I thought of financial success, I assumed it was more important to seek out high rates of return first on what little money I had saved. I could figure out how to save more later. After working in the financial services industry for a few years, however, I realize that the opposite mindset leads to the best results.
Rather than seeking the most attractive returns, I should focus first on how to maximize the amount of current income I can save and invest each year. After all, that’s where the real strength of investing—the power of time and compounding—adds the most long-term value.
Here are four reasons to focus on your savings rate, not your rate of return, during the early stages of your career.
1. Fresh Out of School, Fewer Financial Commitments
Even though you may just be starting your career, this is actually the time of your life you’ll have the most financial flexibility. That makes it especially important to establish good financial discipline including your saving habits early—and not feed on the “keeping up with the Joneses” behavior of reaching for that fancy car or apartment.
By continuing your accustomed lifestyle as a college student for a few additional years after graduating, you can instill the habit of living beneath your means. This provides you options, including the ability to invest any surplus cash flow you may come into. Then as you advance in your career and earn more, you’ll be positioned to save and invest more as well.
The more you set aside in your earlier years, the more time works to your advantage in maximizing your wealth. Not only will your contributions have more time to grow, the return you make on them will have more time to compound, ultimately helping you achieve your long-term goals.
Whether you’re embarking on your career or amid your professional journey, do your future self a favor by automatically saving a portion of your paycheck into an investment account each month.
Start by maxing out your company’s 401(k) match, followed by your Roth or Traditional IRA. Once you’ve reached the maximum allowable in your tax-advantaged accounts then start saving and investing in an individual account.
2. You Can Control Your Savings Rate
Your savings rate can be boiled down to a simple equation: Income - Expenses = Savings Rate. When determining your savings rate, you don’t have to wait around for economic conditions to change or the stock market to turn. You’re the one in control. By working hard to increase your income, or strategically reducing your expenses, you can increase your savings rate.
Even if your income and expenses feel out of control right now, you can take steps to stabilize them. Start by tracking your expenses and income for a few months, so you can see where there is room for improvement. Then, work toward contributing at least enough to your 401(k) or company retirement plan to get your full employer match (which is free money on the table).
Once you adapt to living off of your paycheck after automating these savings, you won’t miss them. You can then increase your contributions as you receive raises or bonuses without compromising your current lifestyle.
3. In the First Few Years, Saving Produces the Most Growth
Investing is a lot like farming. While it’s impressive to see a big harvest (or a million-dollar account balance), none of it is possible without good preparation. Just as a booming harvest requires healthy soil, cared-for seeds and faithful tending, financial success requires diligent planning and a commitment to following that roadmap.
In fact, in the first few years of your career, your savings rate is the primary driver of the speed at which your nest egg grows. As you can see in the chart below, the amount you save to your investment accounts in the first 10 years will actually produce between 50 - 90% of the annual growth.¹
Looking beyond the first 10 years you start to see the harvest. Eventually the growth of your investments exponentially outpaces the amount of cash you are saving.
4. Develop Your Saving Habit Now, Thank Yourself Later
One of the toughest hurdles to overcome is reverting to a simpler lifestyle once you have grown accustomed to a few of life’s luxuries. By starting to save consistently right away, you develop this key habit before it feels like a major sacrifice.
In addition, as you advance in your career, exciting and expensive financial commitments like purchasing a home, getting married, and starting a family will compete for your income.
To get motivated, develop a list of five financial goals you hope to accomplish, a combination of near-term (within the next five years) and long-term (twenty or more years down the road). You can create these in an app, or just dream with pen and paper.
After you determine how much you need and the time horizon for each of these goals, you can then back into a sustainable savings rate. For step-by-step instructions on this powerful process, read up on reverse budgeting.
Investing early in your career gives you the financial flexibility to pursue new opportunities and achieve your desired goals, both of which translate to a more enriched life.
While no one can predict what investment returns will look like over the next 40 years, we do have the ability to control our current saving habits. Although I have yet to personally reap the benefits of compound interest, I am confident the saving habits I’ve established early in my career will position me well to achieve my financial goals.
1. Source: Michael Kitces, Nerd's Eye View. The Four Phases Of Saving And Investing For Retirement.
A version of this post originally appeared on BrightPlan.com