Sunday, 18 May 2008

Is Savings Rate or Total Return more important in reaching your investment target?

I've recently read a couple of posts discussing whether your investment returns or amount of savings has a bigger impact on your final portfolio value. The analyses provided showed that for periods up to 20 years or so, having a large savings rate ($10K pa instead of $5K pa) had a bigger impact than doubling the ROR from 4% to 8%. My initial response was that this was true looking at a 20 year time frame, but over longer periods the ROR ended up being much more important - especially since your savings become a less and less significant part of your total annual NW increase once your portfolio value grows to 3-4 times your annual salary.

I was looking at a comparison of Moomin's monthly net worth figures since 2003 compared to mine, and found that although his NW had increased eight-fold in the past 5 years while mine had only grown slightly more than two-fold in the same period, our NW had moved almost in parallel over this period:

However, the same monthly dollar change in NW represents a much better performance when you're starting out from $60K than it does starting from $480K ! I then did some quick calculations to compare what average total ROI would be needed to model Moomin's result and mine. It turned out that with the same annual savings rate of $30K my portfolio result can be explained with an average annual ROR of 12% and that of Moomin with the same savings rate and a much higher ROR of 23%!

However, although Moomin appears to be a better investor than I (he definitely takes a more professional approach) the ROR seemed a bit high. So I then had a look at what would be the result of a lower ROR but higher annual savings rate. Using the same $30K annual savings rate and 12% ROR for me, but higher savings rate ($45K) and more modest ROR (15%) for Moomin, I get a chart that appears to model the actual results just as closely (I haven't bothered doing any statistical analysis though):

While I think my annual savings rate averages around $30K pa during this period, I have no idea what Moomin's average savings rate has been - although I'm sure Moom knows exactly what his ROR and savings rate are ;) - so I can't tell which model is more realistic. But the point is that the same results can be obtained (over this short time frame) by EITHER getting a higher ROR OR by boosting the savings rate.

As risk is directly related to ROR, it would appear that boosting your savings rate is a more prudent method for achieving your investment goals. That is, trying to cut expenses and increase income in order to boost your savings is a much more certain route to wealth than shooting for amazing investment returns. However, as your NW becomes much larger than your annual salary it becomes more and more important to attain the maximum investment return commensurate with the level of risk you are comfortable with, and to minimise fees and charges.

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The Skilled Investor said...

I think that these are excellent observations. The savings rate is always the dominant lever of control that an individual has.

The individual really has not control over what the market will deliver. An asset allocation that is inappropriate to the emotional/rational risk profile of the investor is just asking for either frustration with under-performance on one side or panic self-damaging actions on the other side.

Pick the appropriate asset allocation, stay invested at that level with broadly diversified extremely low cost mutual fund and ETF investments.

After that the only real lever of control is savings. Boost income and/or control expenditures and build asset buffers for the unknown and unknowable future.

mOOm said...

Interesting. My rate of return over that period was 25% per annum. One reason is I am reporting in USD and you in AUD when we both have a mix of Australian and US/international investments. And you have a lot of Sydney real estate in the mix which has gone much of anywhere in that period.