As investors, we are understandably focused on achieving the highest return possible. The higher our return, the more money we make and the sooner we can retire. So it is of course important that we make our money work as hard as possible.
But if we are serious about building an attractive nest egg and a comfortable retirement, our focus should be more about the amount we save, rather than the return we can expect. Of course both are important, but when dealing within the range of realistic investment returns it turns out that the amount saved tends to be the more important factor.
Consider two investment portfolios, both worth $10,000. The first portfolio (Portfolio A) manages to achieve an annual rate of growth of 7%, while the other (Portfolio B) manages to achieve a more favourable 10% per year. Below is a summary of how these portfolios perform over various time frames.
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Obviously, Portfolio B has done best, but what is interesting is how much difference 3% can make over the long term. In fact in this example, it results in almost twice as much profit after 20 years! What also stands out is that both scenarios are far from adequate to provide for any reasonable retirement – even after 20 years. Indeed, in order to grow your capital to a reasonable level, say $500,000, your initial $10,000 would need to experience consistent compound growth of almost 23% per year for 20 years! Either that, or you would need to start with a much larger initial investment.
However once you start to factor in the effects of regular contributions, you will notice a significant difference, even if those contributions are small. For example, look what happens when we plan to save $50 each week, and invest this into each portfolio at the end of every year (that is $2,600 in total each year).
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Although $50 per week might not sound like much, it has obviously had a significant impact on both portfolios. Indeed, the additional contributions have increased the value of each portfolio by more than 3 fold. So you can see that while a small difference in the rate of annual return can result in a big difference in long term results, regular contributions are far more influential in building wealth.
When you start to think about retirement, and it’s never too early to do so, you first need to consider the following points:
- Your current investment capital
- How long until you plan to retire?
- Your targeted capital amount
- What level of growth can you realistically expect for your investments?
- How much can you regularly save?
What will soon become apparent is that there is little you can do about most of these. How much money you have to invest with right now will depend on what you have managed to previously save, while your time left to retirement will depend on your age. Your targeted capital amount will depend on the lifestyle you plan to live in retirement, but if you wish to avoid living on bread and water, you will require a minimum of at least $500,000 (and due to the effects of inflation, you are likely to need much more if retirement is a long way off). And while it is a safe assumption that over time we will experience growth rates that are broadly in line with long term averages, the degree to which we manage to outperform is difficult to anticipate, as are periods where market returns deviate significantly from historical norms.
So finally we are left with the only thing we have much control over – the amount we save. The good news though is that it is the most influential variable that will impact on your long term wealth and, as we have demonstrated, even modest savings will boost your results substantially. So prepare a budget and savings plan as soon as you can. Then you can focus on the much more interesting and exciting business of boosting your rate of return.
Make the markets work for you