2 min read
Thought experiment: Person A invests $5,000 each year for 20 years and earns 8% annual returns. Person B invests $7,979 each year for 20 years and earns 4% annual returns. Which person will have more after 20 years?
It turns out that they will both have $247k.
Although person A experienced two decades of solid 8% annual returns compared to the mediocre 4% annual returns of person B, the higher savings amount by person B allowed her to make up the difference in investment returns.
The table below further illustrates this point. It shows how different annual investment amounts can lead to the same ending amount after 20 years, despite differences in 4% and 8% annual returns:
The chart below shows another way to visualize these numbers. The size of the circle represents the ending value after 20 years. The-x axis represents the annual rate of return on investment. They y-axis represents the yearly investment.
This little thought experiment proves an important point: A high savings rate can often offset sub-par investment returns. While it’s impossible to predict what type of returns the market will provide in the future, it’s possible to make up for mediocre returns through maintaining a high savings rate.
Note: I was able to find equivalent combinations of savings and investment returns by using this tool: The Equivalent Savings Plan calculator
Zach is the author behind Four Pillar Freedom, a blog that teaches you how to build wealth and gain freedom in life.
He quit his day job as a data scientist in 2019 because he was able to earn enough income from profitable websites to replace his salary. He now teaches people how to start and grow their own profitable websites from scratch in the Income Community.
Zach's favorite free financial tool he's been using since 2015 to manage his net worth is Personal Capital. Each month he uses their free Investment Checkup tool and Retirement Planner to track his investments and ensure that he's on the fast track to financial freedom.
His favorite investment platform is M1 Finance, a site that allows him to build a custom portfolio of stocks for free, has no trading or maintenance fees, and even allows him to set up automated target-allocated investments.
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Hello,
Thanks for the article. I’m just wondering when you say high savings rate, do you mean the amount of capital injected into the stock market yearly or savings into the bank?
I try not to hold too much cash; 6 months of emergency and a war chest and some spending money. The rest I’d like to deploy them to investments when the bear comes.
The higher the savings rate, the less important the return, especially over the relatively short-term (a decade or so).
An interesting side note, though, comes from the $15,959 a year at 4% versus the $15,000 a year at 8%. The latter comes out ~ 50% (or about $250,000) ahead after 20 years. That effect is of course magnified the further out you look.
Without savings to invest, returns are meaningless. But once you start investing significant amounts, even a percent or two can make a seven-figure dollar difference over many decades.
Love the illustrations. Keep ’em coming.
Cheers!
-PoF
“Without savings to invest, returns are meaningless.” Exactly! This is something that is true but doesn’t get discussed enough in the finance community. Thanks for the feedback, PoF 🙂