Your Investment Plan Means Nothing If You Don’t Do This
We could talk until we’re blue in the face about the right way to invest, and to be honest with you none of it would matter if you didn’t handle one thing first.
This is hard for me to say. Because honestly, I love to sing the praises of index investing, preach about the importance of minimizing your investment costs, and laud the simple power of diversification. I tend to nerd out when it comes to those simple ways that you can cut through a lot of the investing BS out there and get your fair share of returns without all the stress and hassle.
But the truth is that all of that focus on returns is much ado about pretty much nothing. Because for the first DECADE of you investment life, the returns you earn, good or bad, barely matter at all.
There’s only one thing that really matters, and the good news is that it’s the one thing you’re in complete control over.
Your savings rate.
The power of saving
It’s hard to really appreciate just how powerful it is to save more money without a visual. So let’s make one!
We’re going to compare two people, Frank and Sarah. Both of them make $75,000 per year and are ready to start saving for financial independence, but they go about it in different ways.
Frank frees up enough room in his budget to save 5% of his income. He also spends a lot of time reading up on the finer points of investing, creates a smart investment strategy, and is lucky enough to live through one of the good periods for the stock market. All of that gets him a 10% annual return from his investments. (Note: This is VERY high. 7-8% from the stock market is likely a more reasonable expectation.)
Sarah takes NO time to learn anything about investing. In fact, she just puts all of her money into a savings account at the local big bank which earns her a big fat 0% return. Maybe not the best move in the world, BUT she also finds enough room in her budget to save 10% of her income.
So we have Frank, saving 5% of his income and earning 10% returns. And we have Sarah, saving 10% of her income and earning 0% returns.
Who does better? Here’s the chart:
Remember, Frank is earning 10% returns every single year, which is probably way more than any of us should expect. Sarah is earning nothing.
And it still takes 14 YEARS(!!!) before Frank’s incredible returns are able to overcome Sarah’s savings rate. Sarah ends each of the first 13 years with more money.
THAT is the power of saving.
How quickly can you reach financial independence?
One more chart for you. This one comes courtesy of this excellent post from Mr. Money Mustache, and once again shows just how powerful even a small increase in your savings rate can be:
That math works no matter what your income is. And it assumes you’re starting from $0, so if you already have something saved you may be able to get there even sooner.
It’s pretty simple really: the higher your savings rate, the quicker your path to financial independence.
Stop stressing. Start Saving.
None of this is to say that you shouldn’t spend at least a little time figuring out how to invest properly. There are some easy ways to make sure that you maximize your potential returns, and it’s a good idea to take advantage of them. Every little bit helps.
But the moral of the story is this: if you want to reach financial independence sooner, STOP worrying about how to get better returns and START figuring out how to save more money.
It’s as simple as that.
Want more detail on how to actually invest all that money you’re saving? Here it is: The Only 7 Investment Decisions That Matter.
An excellent point for those of us fairly new to investing. Focus on the right percentage.
Yep! It may not be sexy, but it’s the most important part of your plan by far.
I agree that actually saving is very important. But Mr. Money Mustache’s chart make’s it seem that if you could save 100% of your income, you could retire next year even if you have nothing saved. I know I couldn’t live out the rest of my life on only one year’s worth of income, but otherwise, the chart is interesting.
I agree that the idea of saving 100% of your income falls outside the realm of realistic assumptions, and therefore doesn’t make a whole lot of sense to consider. BUT if you’re saving 100% of your income, the extension of that assumption is that you actually have no expenses (otherwise you wouldn’t be able to save 100% of the money coming in). And if you didn’t have any expenses, you would technically be financially independent even if you had nothing in savings.
Again, you’re absolutely right that at that extreme it’s a bit of a silly/pointless exercise because the reality is that everyone has to spend something to survive, but the math does work.
This is a great look at the “other side” of the numbers for investing. How much you save reflects how much you’re able to live on, and if you can live on less now you don’t need as much to retire. This was eye-opening for us. We used to think when we paid off the mortgage we’d finally do and buy some things we’d been putting off. But now we want to keep our expenses low (within reason) and save/invest half our (one) income so we can “retire” to more flexible, second careers early.
That’s a great plan! And you’re absolutely right about the double benefit of saving more/spending less. More is going into savings AND you need less savings to support your spending. It’s a pretty big win!
Great post Matt! My wife and I were just talking about this concept a couple days ago.
Another good example is if person A is earning $150K/yr and not saving any $ while person B is earning $75K/yr and saving ANYTHING, even just 5%/yr, then person B is going to be financially free before person A.
A great strategy to get there sooner is to keep you “standard of living” in check, especially as you’re earnings increase. This way any increase in earnings can go directly to your Retirement/Financial Freedom fund!
Agreed! Putting 50% of every raise towards savings is a great strategy to keep you ahead of the curve. Another great strategy is to increase your savings rate by 1% every 6-12 months, even without a raise. Those small changes aren’t too much of a shock to the system, and over time they can add up to a big difference.
I don’t know, I honestly would rather be Frank in this scenario. Yes, he lags behind for the first 13 years, but now for the REST OF HIS LIFE he will be ahead of Sarah, getting exponentially farther away from her while still saving only half of what Sarah does. 40 years down the line with retirement on the horizon Frank will be way better off. I think this shows the power of compound interest more than the power of saving.
But not to dismiss your point, that yes, savings rate is very important. But you still won’t get ahead if you don’t harness the power of compound interest!
Noelle, you make a great point and for the most part I completely agree. After you’ve been saving for a while your returns start to matter a lot, so at some point it makes sense to learn at least the basics of forming a smart investment plan. I actually talk about that a lot on this site, such as here and here.
The point here is NOT to simply accept 0% returns for your entire life, but to start your investment plan by focusing first and foremost on your savings rate, as that is what will do the most to get you going. I see many people who get caught in the trap of trying to maximize returns, which either leads to them being too intimidated to start or gets them focused on minor details like “should I be 60% or 70% stocks?” that won’t have much of an impact.
So the lesson is essentially this: first and foremost make every effort you can to align your savings rate with your goals. THEN start learning the basic principles of good investing and apply them. That way you get the best of both worlds.
I love the visuals. Really motivating.
Thanks Michelle. Glad to hear it!
Great post! I completely agree. First figure out your savings rate and how to maintain it consistency. Then how to manage your returns and fees. An early start helps the most though no matter what. Habits are formed and the longer you have to take advantage of compounded interest.
A very simple but powerful concept! I love it! Now just imagine if sarah in your example was getting even just a measly 3% on her money which is very attainable. sometimes its easier to just keep it simple. Great post!