Tuesday, 25 October 2011

Savings Rate or Investment Returns?

I see several articles and energy spent on figuring out how to maximize ones investment returns.  There are tons and tons of websites dedicated to guiding you on how to increase your stock market returns, or to find the best loan rates, or the highest FD rates.  Yes, I believe all of this is important, since you wouldn't want to be stuck with a less than optimal investment return, when better returns are available for the same product and risk profile.  However, the key realization you need to have is that, investment returns are not in your control.  You can try your best to increase your returns by a few percentage points, but for the most part you have no guarantee that this will happen.  Also, going for increased returns always goes hand in hand with a higher investment risk that you will have to take on. 

Instead I propose that you should spend your energy in figuring out how to increase your savings rate.  For starters this is completely in your control, so you can decide and implement any savings strategy, as long as you have the discipline for it.  Also most times I have found that a small increase in your savings rate, can easily offset any lower investment returns that you might see.

Here is a table that illustrates this principle.  I have calculated how many years it would take to save up 10 times your annual salary, if you make 0% to 20% returns (on the Y axis of the table), for different savings rates from 10% to 90% of your annual income (on the X axis of the table)

The first row is the simplest to understand, since it assumes 0% returns, or the equivalent of taking all your savings cash and keeping it in a bank locker.  Therefore, in this case, if you save 10% of your annual salary, it will take you 100 years to save up to 10times your annual income.  As you increase your savings rate, the number of years reduces proportionately.  If you are able to save 50% of your annual income, you can achieve your 10X target in 20years.  However, in real life, nobody keeps their money in a bank locker with 0% investment returns (unless it is black money!)

So lets take the example of 8% annual returns. In the current scenario of high interest rates, it is easy to achieve 8% investment returns by simply investing in low risk debt instruments (like FDs, MIPs, etc)  In this case, if you are able to save as little as 30% of your annual income, you can save up 10 times your annual salary in 16.9 years.  This may seem like a long time, but if you start at the age of 25, by the age of 42, you will have 10X your annual salary in your investment portfolio.  That is a very strong position to be in!  However, if you are not willing to wait that long, you can increase your savings rate to 50% (save half your annual income)  This will help you reach your goal in just 12.4 years.  Again starting at age 25, you would have met your goal at the young age of 33!  Clearly this illustrates the value of increasing your savings rate.

If you are willing to take on more risk, you can aggressively invest in equities, real estate, and these days even in gold.  Assuming an aggressive investment returns of 12%, you can see from the table that 30% savings will help you reach your target in 14.2 years, while an increased 50% savings rate will help you get there in just 10.8 years. 

This should clearly drive home my point that though investment returns are a good thing to chase after, an increased savings rate is a more powerful tool (and completely in your control) to help you reach your retirement corpus accumulation target.

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