Thursday, October 4, 2012

Your Savings Rate Trumps Your Investment Returns

If you're like me, and you're seeking financial independence at a relatively young age, you're looking for the most efficient and reliable way to the promised land. I've found that the best way to financial independence is to save large parts of my net income by living below my means, staying out of debt and investing said savings wisely. But, while "investing wisely" can be somewhat subjective, saving a large part of your income is not.

Investing In Dividend Growth Stocks 

I choose to invest my savings into dividend growth stocks. I like to purchase shares of high quality businesses that have a long history of being efficiently run and returning value to shareholders. I like investing in businesses that provide society with needed services and products that people crave. These companies have "wide economic moats", or strong defenses against competition. They usually have large distribution and supply networks, household brand names and pricing power which allows them to raise prices on their products or services over time. These increased prices drop down to the bottom line and allow these businesses to raise dividends over time. I also like to invest in these companies at attractive prices, which provide me a margin of safety against market downturns.

Savings Rate Vs. Investment Returns 

This is all well and good. Investing your hard-earned money in high quality companies that pay rising dividends at attractive prices is a surefire way to success. But, as much as I consider myself an astute investor, the most important consideration to your journey to financial independence should be your savings rate first, and your investment returns second. So, you need to be a saver first and an investor second.

There are three factors at play when you're considering how much money you'll have at a future date. Contributions, time and rate of return are the inputs you're going to use when trying to figure out how long you'll need to save, how much you'll need to save and how long you'll have to do it for. This article is targeted towards people who are interested in retiring at a relatively young age. For "normal" people looking to retire at 65 years of age or older, time can make up for any shortfalls in either contributions or rate of returns. But for individuals looking to seek complete financial independence before 45, time will not be such an overpowering force. 

I've figured out that while I take my investments seriously, my savings rate will be a much more powerful ally than my investment returns due to the fact that I'm trying to become financially independent at such a young age (40).

Using Myself As An Example 

Consider myself as an example. I started this journey at 28 years old, with about $5,000 in the bank to contribute towards investing. That makes my journey to retire at 40 a 12-year journey. To illustrate the power of savings, let's consider two savings rates and two rate of returns for this 12-year journey. I average approximately $4,000 a month in income. I try to save at least 50% of my net income every month. So, if we assume a 50% savings rate we would assume monthly contributions to a dividend growth portfolio in the order of $2,000 per month. 

First Example: Large Savings Rate, Low Return

The first calculation I performed involved starting with $5,000 and contributing $2,000 per month over a 12-year timeframe. I used a very conservative 5% rate of return, compounded monthly. A 5% rate of return is well below the average rate of return for the stock market as a whole. This example considered saving a large amount of money and contributing those savings regularly while getting a sub-par return on your money. That example looks like this:

Initial Investment: $5,000
Regular Investments: $288,000
Total Interest: $111,266.40

Ending Value: $404,266.40

Hmm, not bad. A fairly conservative dividend growth portfolio worth over $400,000 should be able to throw off at least $14,000 (3.5%) per year in dividends while still providing capital gains as the underlying businesses continue to become more valuable. A portfolio of that size could just about cover 100% of my expenses as they stand today. But, what if I'm unable to save 50% of my income every month? What if due to decisions I made when I was much younger I'm only able to save 25% of my net income every month? That's still much higher than the average American, right? And, maybe I'll get really great returns on my money and make up for the lack of savings? I can dream...right?

Second Example: Low Savings Rate, Above Average Return

Let's take a look at another example. Let's double your rate of return this time. Yes, I'm going to double the return in this second example. So, we're going to assume a 12-year 10% interest rate. This is slightly above the long-term stock market returns. The catch is that I'm going to halve the contributions and cap them at $1,000 per month. That's 25% of a monthly net income of $4,000. We'll still use the same 12-year assumptions. That example looks like this:

Initial Investment: $5,000
Regular Investments: $144,000
Total Interest: $146,259.77

Ending Value: $295,259.77

Well, that's still a large chunk of change. However, it would be difficult to consider yourself financially independent unless your expenses are almost unbelievably low. And, if they are that low you will have likely been able to contribute more in regular investments all along.  A portfolio of that size would throw off $10,300 (3.5%) per year in dividends. So in this example you got an above average return, but still fell woefully short of your goal after 12 years. You can see the vast difference in portfolio sizes and yearly dividends between these two expenses. So, while getting an above average return on your money is certainly wonderful, increasing your savings rate is paramount.

Third Example: Low Savings Rate, Outstanding Return

Let's consider a third example, just for fun. This time I'll triple your rate of return from the first example. We'll assume a full 15% interest rate on the portfolio over a whole 12-year period. This would be extremely difficult to attain, but let's see how it turns out. We'll still consider regular contributions of $1,000 per month, for a 25% savings rate.That example looks like this:

Initial Investment: $5,000
Regular Investments: $144,000
Total Interest: $284,497.23

Ending Value: $433,497.23

This portfolio is the largest of the three. But, it took a full 15% interest rate over a 15-year period to attain. This might be pretty difficult to attain over such a long period of time. This portfolio barely beat the first portfolio, and it took an outsized investment rate of return to achieve.

Focus On What You Can Control 

What is more repeatable and realistic: a 15% rate of return long-term or a large savings rate? For someone who is intent on financial freedom, you should be able to quickly realize that the power is in your hands with a savings rate, but large investment returns are not completely in your control. Large returns on your investment should be icing on the cake, but as one can see above a large savings rate, and hence large regular capital contributions, can easily overcome sub-par investment returns. 

The best scenario one can hope for is large regular capital contributions through a large personal savings rate and a strong rate of return on your investments over a long period of time. What I try to do is maximize the things I can control. I try to save as much money as I can by performing the best I can at work to increase my earnings and reduce my expenses as far as I can. The larger the spread between income and expenses, the more I can contribute to my Freedom Fund. I can control when and how I invest, and so I try to find high quality businesses that reward loyal shareholders with rising dividends that are trading for attractive long-term prices.

I can't control market forces. I can't control what happens to the Euro. I don't know who's going to win the Presidency and I can't predict where stocks are going to be 5 years from now. But, by maximizing my savings rate and making large regular contributions to my investments, I can overcome the things I can't control.

How about you? Are you maximizing the things you can control? 

Thanks for reading. 

This article was written by Dividend Mantra. If you enjoyed this article, please subscribe to my feed [RSS]

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