Your savings rate, particularly when you’re young, has a much greater affect on your wealth accumulation than higher returns do. The reasoning for this is simple. When you’re portfolio is small, you’re (hopefully) contributing more each month than your portfolio is earning.
Let’s check out how this works with some numbers. Let’s compare two different investors. Each makes $50,000 at age 25 and their salaries increase by 3% per year until they’re 65.
Max: Saves 6% of his salary before tax, spends time finding the best investments and earns 10% per year. To earn this return he has to follow his investments more closely, and tends to stress over his investment options.
Ralph: Saves 12% of his salary before tax. This is double the savings rate of Max. However, Ralph doesn’t like to worry about his investments so he invests in an index fund that earns him an average of 6% per year. He rarely checks his portfolio balance and doesn’t stress about fluctuations in his balance. He doesn’t waste a lot of time following the market.
As you can see, Ralph is saving a higher percent of his income, but Max is earning a higher rate of return by spending time carefully choosing winning investments. Below is how their wealth would accumulate.
Max doesn’t catch up to Ralph’s wealth until he’s 54. This illustrates the heavy impact that a savings rate has on wealth accumulation. If you’re saving more, you have plenty of time to find that investment strategy that is going to yield a higher return. If you’re not saving enough, even a great investment strategy won’t help you catch up.