How Important is Your Rate of Return?

When I hear people say that they’re hesitant about getting into investing, one of the most common reasons seems to be that they don’t know how to do it. There’s so much in the news about whether “now is the right time to invest”, there are so many “experts” touting different investment strategies, that it’s just too overwhelming and they end up doing nothing.

Today I want to talk about why you can ignore all of the confusion and focus on one simple thing.

What is all the noise really about?

When you hear some expert on the news talking about current market conditions and whether now is a good time to invest, what is he really talking about? What is the reason behind all of these different people touting their different investment strategies? Why does any of that matter in the first place?

It all has to do with rate of return. All of that advice is assuming that you want your money to earn more money at the highest rate possible.

Obviously, your rate of return of return matters. If you had a choice between earning 8% or earning 4%, which one would your choose? All of us would choose 8%. It’s a stupid question. So if you’d rather earn 8%, you should spend most of your time trying to figure out how to get there, right?

Dead wrong. Especially when you’re just starting out, rate of return is actually one of the least important factors. Let’s take a look at an example to see what I mean.

Rate of return vs. savings rate

I created a simple Google spreadsheet to help me run these numbers myself, and I made it into a template so that you can use it to run your own numbers: Rate of Return vs. Savings Rate.

In the default example, I’ve assumed that you’re starting with nothing in your investment account. I’ve then created two scenarios. In Scenario A, you’re contributing $100 per month and earning 8% on your investments. In Scenario B, you’re only earning 4% but you’re saving $200 per month.

The results are pretty amazing. Even with double the rate of return, it would take 29 years before your balance in Scenario A would surpass your balance in Scenario B. In other words, doubling your savings rate has a MUCH bigger impact on your balance than doubling your rate of return.

For an even more ridiculous example, you can set the rate of return in Scenario B to 0%. Even in that absurd example, it still takes 16 years for the higher rate of return to outperform the higher savings rate.

The implication for you

Conclusion #1: Starting to invest is much more important than figuring out the best investment strategy.

Conclusion #2: Spending your time figuring out how to increase your savings rate is much more important than spending your time trying to figure out how to increase your rate of return.

This is good news! Increasing your savings rate is directly within your control. Increasing your rate of return is not (the fact of the matter is that even most professionals do not beat the market).

So spend your time figuring out how to increase the amount you save. You can do this by cutting some costs or by earning more money and redirecting that towards your savings. Either way, you’ll get yourself much further ahead than you would by focusing on your return.

The but…

I am not in any way against investing for a higher rate of return. I think that formulating a good investment strategy is important and will certainly help you over the long term (another good resource for starting out is here). And I do think that there are reasonable measures that allow you take some more risk and expect a higher return, such as putting money into the stock market. I just don’t think that rate of return is where your main focus should be as you start out.

As your balance increases, your rate of return will likely start to outpace your contribution rate. This is both because the same percent return is a larger absolute amount when you have a larger balance, and because your contributions as a percent of your balance will likely be smaller as your balance grows. However, as we saw in the examples above, you’ll likely need to accumulate a good amount of money before this really starts happening. For now, the amount you’re saving will likely still be much more important than the amount you’re earning.

So get started

You don’t need to be an expert to get started investing. All you need is some extra money you can put away for tomorrow.

Ignore the confusion. Don’t sweat the details. Just get started. The more you save, the better you’ll do.

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0 Comments... Be the first to comment
  • William_Drop_Dead_Money April 26, 2013

    Great breakdown! I’m bookmarking this post

  • Matt Becker April 27, 2013

    Thanks a lot! Glad you like it.

  • Laurie @thefrugalfarmer April 27, 2013

    Matt, I love this. We are just now starting to educate ourselves about investing as we whittle away our debt, so that we’re ready to go when the time comes to invest. This is a great basic post that was easy to understand for us. Thank you!

  • The Frugal Path April 27, 2013

    Good point Matt. When you’re younger, and have more time, the savings rate is key. But when you get older, and have more assets, often your Rate of return is key. It’s funny that it works out this way though.

    When you’re young you can take more risk but often have less income to save. When you’re older, your a bit more risk adverse because you’ll need the money soon, but you’ve probably got the income to invest more.

  • Matt Becker April 27, 2013

    I’m glad it was helpful. Good investing can actually be really simple. A good site to help you start out is http://www.bogleheads.org/wiki/Main_Page.

  • Matt Becker April 27, 2013

    Very true. It’s an interesting paradox. The flip side of that is that when you have more assets, you don’t need as big a rate of return to generate the same amount of earnings. It could really read like this:
    1. When you’re younger, the amount your are currently saving is key.
    2. When you’re older, the amount you previously saved is key. That is, the more you have saved, the more it earns for you, regardless of your rate of return.

  • Laurie @thefrugalfarmer April 27, 2013

    Thanks, Matt. We’ll check that site out.

  • Holly Johnson April 30, 2013

    Starting sooner rather than later is the key. That way you can weather all of the ups and downs while still having your investments move in an upward trend!

  • Matt Becker April 30, 2013

    Sooner is definitely better. It’s also important because you build a base so that your future returns actually earn you more money.

  • Matt Becker May 1, 2013

    Glad you liked it! I do think there’s value in taking some calculated risks through simple asset allocation, but you’re right that it’s definitely most beneficial to focus more on the saving side of things.

  • Pretired Nick September 27, 2013

    Start today and put in as much as you can. Simple as that!

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