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Should I save or invest?

If someone asked you what you thought was more important: the amount you invest each month, or the rate of return on your investments – what would you say?

In my experience, most people tend to say their returns.

And that’s understandable given how much time investors devote to eking out a few extra basis points of return each year. There are hundreds of thousands of books devoted to how to maximise the returns on your investments. The number of blog posts and research articles devoted to investment returns probably runs into the millions. And its hard to turn on a financial news station or read the financial section of a newspaper and read anything other than subjects related to your investment returns.  

But you rarely hear about the other side of the coin.

Your savings rate

 

Your savings rate is the percentage of your income saved and invested, and it plays a surprisingly large part in helping you on your investment journey.

Let’s have a look at how much difference your savings rate can make. If we assume your post-tax income is £40,000 a year, and you receive salary rises in line with inflation, then what does your portfolio value look like after 40 years with different savings rates?

 

Should I save or invest 1

Looking at the left-most set of bars, the chart shows that if you started with no investments at all, but saved 5% of your income each year, you could be really unlucky and receive a 0% real rate of return, in which case your portfolio would grow to £80k after 40 years (the furthest left bar). But it could grow to anything up to £253k at a 5% real rate of return.

If you save 30% of your income each year (the furthest right set of bars), your portfolio can grow to anything from £480k with a 0% rate of return, to £1.5m with a 5% return. And that’s in real terms.

The difference in portfolio value between a 5% savings rate and a 30% savings rate at 5% returns a year is over £1m. That’s a final portfolio value 6 times as large if you save 30% vs saving 5%.

Even with a 0% rate of return, saving 30% of your income will result in a portfolio almost twice as large as if you’d received 5% returns per year, but had only saved 5%.

The idea being that the more you invest, the more there is to compound. By increasing your savings rate early, you increase your portfolio value at the start of your compounding journey, and create a larger pot which compounding can work its magic on.

The great thing about your savings rate is that you have control over it. You can’t control how much you receive from your investments (but you now know that it’s a function of your risk tolerance, time horizon, and the fees you pay), but you are able to choose which set of bars you belong to in the chart above. Moving from the 5% bars towards the 30% bars is within your control – and having something within your control which has such a big impact on your final portfolio value can be a really powerful tool.   

Who wants to be a millionaire?

 

Another great thing about increasing your savings rate is that the bigger your savings rate is, the less dependent you become on your investment returns to meet a specific goal.

For example, if you wanted to become a millionaire in your lifetime, then increasing your savings rate means that you become less reliant on having huge returns from your investments to get to £1m. If we take our £40k a year post-tax salary example from before, we can see how long it would take to reach that £1m goal at different savings rates:

Should I save or invest 2

Now, obviously nobody can get to a 100% savings rate. Even a 50% savings rate is unrealistic for 99% of people, but it’s useful to see what happens when savings rates are taken to the extreme.

The chart shows that increasing savings rates not only cuts down on the number of years it’d take to become a millionaire, but it also shows that once your savings rate gets high enough (the far right of the chart), the rate of return you receive doesn’t matter that much.

This means that increasing your savings rate has a much larger impact at lower savings rates.

Using the chart above, assuming 5% real returns, increasing your savings rate by 10% from 5% to 15% cuts your time taken to become a millionaire by 21 years (66 years to 45 years). But increasing your savings rate from 40% to 50% (the same 10% increase), only cuts down the time by 4 years (29 years to 25 years). That same 10% increase in your savings rate has a much bigger impact if you start from 5% savings than if you start from 40%.

You can see that by looking at the steepness of the curves. All the lines are much steeper on the left hand side of the chart, meaning that increasing your savings rate from a low starting point has a much bigger impact on the time it takes to reach your investment goal than increasing an already high savings rate.

There are big diminishing returns when it comes to increasing your savings rate, and that’s great because, in reality, very few people are going to be able to save over 50% of their income.

And this fact makes intuitive sense. If you invest, say, £1,000 a year, then even if you get a massive return of 10% in your first year, then that’s only £100 added to your portfolio. But if you increase your savings rate by £500 a year to a total of £1,500 a year, then you’re adding £500 to your portfolio regardless of returns – 5x what you would have added if you’d received the best investment returns you could’ve hoped for. So with low portfolio values, saving more is far more beneficial than investment returns.

So, which is more important?

 

We’ve seen that increasing your savings rate makes a huge difference at low savings rates and low portfolio values. But as you save more, and your portfolio continues to grow, the value of your portfolio is less and less affected by your savings rate, and increasingly affected by your investment returns.

Let’s skip forward in time and assume that the £1,500 a year has now become a £1m portfolio. If that £1m portfolio gains 5% a year, those returns would add £50k to the portfolio’s value. That increase in value has come from investment returns, and would be really difficult for most people to add by saving.

As a result, the relative importance of savings rate versus investment returns changes over time. Saving is more important early on to build a big portfolio, but once you’ve built a large portfolio, your returns become more important than your savings rate.

If we continue with our £40k post-tax salary example, and assume a 10% savings rate, a 5% rate of return, and increases in salary of 5% a year above inflation, then we’re able to see graphically the relative importance of the saving rate vs rate of return:

 

Should I save or invest 3

 

As you start investing with a small portfolio, the amount you save each year will have a bigger impact on the value of the portfolio than your investment returns. As your portfolio grows, investment returns start becoming more important than the amount you save, as the amount added to the portfolio from investment returns start to become larger than the amount you’re contributing through savings.

So the answer to the question of “what’s more important: the amount you save or your rate or returns?” is that it depends.

When you’re starting out investing, the amount you invest is more important. But as compounding takes a hold of your investments over time and your portfolio begins to grow, you hand over your portfolio to the gods of compounding. The larger your portfolio becomes, your investment returns start to matter more than your savings rate, and you’re able to let compounding grow your portfolio for you.   

Conclusion

 
  • Your savings rate can massively boost your investment portfolio over time
  • Your savings rate is completely within your control
  • If your savings rate is low, even increasing your savings rate by a small amount can be extremely helpful, and has a much bigger impact than if you already have a high savings rate
  • Your savings rate matters most at low portfolio values, but as your portfolio grows, investment returns start to matter more

 

For those that want to get started with investing, but aren’t sure if they have enough to invest, the next post in this series on the basics of investing answers the question of ‘How much do I need to start investing?

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