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June, 2018

THE RELATIVE IMPORTANCE OF HIGHER RETURNS VS. NEW SAVINGS OVER TIME
by LARRY

Thanks to the power of compounding, for each $10,000 invested at a typical 10% average annual equity return over a 40-year period (without distributions, taxes, or redemptions and with all dividends reinvested) one achieves a $385,310 advantage over the investor who comes to the table late and only has twenty years to see his assets multiply in value. The person who begins investing in a low-cost S&P 500 Index fund at age 25, starting with $10,000, sees that typical average return of 10% annually, and takes nothing out till at least 65, will have $452,585 after 40 years, just from that one initial investment, whereas the person who starts at age 45, in otherwise the same circumstances will have a sum of just $67,275, in each case not factoring in any additional investments that might have been made after the outset.


The rewards of investing for higher returns (letting our money grow in financial instruments such as real estate investment trusts [REITs], common stocks, or stock mutual funds, that hopefully increase our wealth and at a rate higher than inflation) are of greater force the longer we have to invest, everything else being equal. By contrast, the benefits of saving (putting more funds into our nest egg, for instance in Certificates of Deposit, money market funds, or Treasuries, that generally have lower risk than greater return investments but also do not keep up with inflation as well) are greater the closer we get to using the nest egg for its intended purposes, such as advanced education, retirement, etc.




Of course, if one has sufficient dollars to set aside for and keep in equities or real estate and add to lower-risk assets, it is great to emphasize both investing and savings equally, regardless of age. However, most people find they are often making choices between a greater emphasis on simply adding new savings vs. investing for higher returns. If, for example, they get the priorities mixed up and put the stress mainly on accumulating low-risk assets in the first half of their careers and only turn to higher risk investments in the final half of their working lives, the result could, from that choice alone, be a far smaller nest egg at the intended conclusion of their working lives. After inflation, the buying power of short-term bonds, money market reserves, and Certificates of Deposit is diminished over time, so the use of mainly savings in one's first 20 years of a common 40-year employment career, is to wind up with less, in terms of what it will pay for, than when one started. And investments in stocks do usually beat inflation and offer the benefits of compounding, but such benefits are relatively lower in the first couple decades after purchasing one's stocks or real estate, and these assets are far riskier. A 2008-type plunge in real estate and stock markets shortly before or after one's planned time to retire would have a much more harsh impact if one were only relying on the second half of one's career for building up the nest egg via equities or real properties. Via subsequent bull markets, a younger investor, by contrast, will have much more time to recover his or her lost wealth following severe downturns in the markets.


In a recent article in AAII Journal, "The Impact of Saving Versus Return on Wealth," by Craig L. Israelsen, Ph.D., May, 2018, pp. 13-16, and 25, the author notes that if one's average return on investment is at the 10% rate more typical of equity markets but one's rate of new savings is only 6%, one comes out way ahead over a 40-year career span compared with the opposite, sustaining only a 6% return, as from a more conservative allocation of assets, and yet adding new savings at a 10% annual rate. For a worker starting at a $35,000 per year salary at age 25 and getting 3% average raises annually the result of a 40-year career of investing at 10% annual averages and with new savings of 6% would be a retirement nest egg worth $1,259,917 at age 65. On the other hand, a worker who under the same wage conditions puts 10% into new savings and only invests at a 6% average rate of return winds up with $819,429 by 65.


Yet, starting twenty years later, the relative benefits of greater return vs. greater savings are reversed. If in the thought experiment we assume this 45-year-old worker is now making about $63,200 after having been employed a couple decades, also gets average raises of 3% a year, and invests with a 10% average rate of return while adding new savings at a 6% rate, he or she will wind up with $266,657. A worker who under the same employment conditions invests more conservatively for a 6% average annual rate of return yet puts in new savings at a 10% yearly rate winds up with the larger bundle at his or her hypothetical age 65 retirement: $295,214.




For folks who wait to begin building up their nest eggs till in their fifties, the contrast is more stark. Assuming 3% annual average wage increases have continued and still do, our hypothetical worker, currently at age 55, now would be making almost $86,000 a year. With a 10% average rate of return while adding new savings at a 6% rate, he or she will wind up in ten years, at age 65, with just $91,010. A worker who under the same employment conditions invests more conservatively for a 6% average annual rate of return yet puts in new savings at a 10% yearly rate winds up with $126,562 at age 65.


Workers getting well along in their careers but who still have, for whatever reasons, smaller nest eggs, may be tempted during the last decade or so to add in a lot of risky but potentially more lucrative investments, to make up for lost time. A counterintuitive conclusion is that the closer we get to needing to use our nest eggs, the more important it can be to lower our investment return expectations and put the emphasis on adding more in new savings instead. As Craig L. Israelsen notes in his above referenced article, people have control over their savings rates, much less control over the returns in a shorter period on riskier investments. In the United States currently, a large number of employees are approaching retirement age. In a good many cases, they are doing so with nest eggs too skimpy for their likely expenses once having left their careers. Hedge fund giant, Blackrock, has just provided guidance that both stock and bond markets are likely to be significantly lower by this time next year, if not sooner. Meanwhile the markets are fairly high in terms of price to value. Especially since the November, 2016, election, both common stock and real estate properties are substantially elevated. To keep or put a lot of our funds in these, or even more volatile types of assets, in the hope of getting rich more quickly in what time remains before retirement may be asking for trouble.


According to a study by Country Financial released last year, two-thirds of folks in the U.S. are worried about having enough money for their years ahead. Yet lots of workers enjoy higher annual salaries now than they had made on a consistent basis in their younger years. Downsizing and setting aside more of that extra income for post-employment times of greater need may now be wise choices.


DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)



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