Many young investors today are focused on the wrong part of wealth building for their stage in life. The importance of saving money is overlooked.
Instead, they’re chasing meme stocks and the latest cryptocurrency, hoping to get rich quick.
They have seen massive returns in some of these “investments” as people jump on the speculative bandwagon and drive up prices. They have also seen extraordinary losses when speculation ends and the bubble bursts.
Some have been lucky and profited from the upside. Others have been wiped out of all of their savings.
A second type of young investors is playing it a little safer. But they’re trying too hard to beat the market by picking stocks and day trading. As history has shown, many of these investors will also lose that game.
For those who get lucky, the problem is that they are playing with small dollar amounts. The money earned by hitting a “jackpot” isn’t life-changing. And this result won’t easily be repeated.
The wiser approach is to focus on earning and saving as much as you can in the early years. Investment returns don’t matter nearly as much until you have created a large pile of money.
Once you have that large pile of money 10 or more years down the road, however, investment returns really start to matter.
Let me show you why.
A 10x return on $100 is only $1,000. You can beat that in a week of work.
But a 10x return on $1 million is $10 million. That’s a lifetime of earnings.
1 How much you save versus how well you invest
The best way to discuss the importance of saving money versus investing is with a visual example. Let’s run three scenarios.
Scenario 1: Lilly saves $1,000 per year and gets an incredible 20% return every year. This is the return that Warren Buffett has made over his lifetime with Berkshire Hathaway. It’s extremely difficult to do, which is why Buffett is so famous today. So no one can realistically expect to do better than this over long periods of time.
Scenario 2: John saves $2,000 per year and returns 10% every year. This is the average long-term return of the S&P 500, an index of the largest 500 companies in America. Over 10 years or more, this is about what John can expect to earn with a broad all-stock portfolio. But he’s saving twice as much as Lilly. Will this compensate for getting only half of Buffett’s annual returns?
Scenario 3: Greg saves $4,000 per year and returns 0%. Greg is a great saver, putting away 4 times as much as Lilly. But he decides it isn’t worth the risk to put his money to work. So he stuffs it under his mattress instead.
Who do you think will come out on top after 10 years? 20 years? Longer?
1.1 Importance of saving money in the early years
The results of these scenarios for the first 10 years are shown in Figure 1.
Lilly’s amazing returns more than tripled her $10,000 in savings to $31,150. She’s on a great trajectory. But she hasn’t caught up to the other two yet!
John’s $20,000 in savings is now worth $35,062. Nice steady growth. But he’s still behind Greg!
Greg has $40,000 sitting under his mattress at this point. His focus on saving has paid off, and he’s feeling pretty good about himself.
Lilly and John might have done well with their investing strategies, but what really pays off in the first 10 years is how much you can save. If they both had saved as much as Greg and still got their investment returns, John would have $70,125 and Lilly would have $124,602!
1.2 Importance of investing wisely in later years
Lilly, John, and Greg met at a neighborhood block party on year 10. They discussed investing as their kids played in the bounce house.
Lilly walked away from the conversation with pride. Her investment returns completely beat her neighbors. Her investments were going to grow by $6,230 this year, which made her $1,000 in yearly savings look small. So she decided she didn’t need to save any more at this point. She could turn her $31,150 into millions before she retired anyway!
John decided he was on the right path, investing slow and steady in index funds. So he continued saving and investing just as he had done the previous 10 years.
Greg thought Lilly and John were still taking too much risk. What if the market crashed and they couldn’t get those returns anymore? Why weren’t they saving more? He decided to increase his yearly savings to $6,000. And since the $40,000 was getting a little uncomfortable under his mattress, he put it in a trash bag and buried it in his yard.
How do you think the next 10 years turned out for these three?
Let’s take a look at Figure 2.
Greg’s extra savings kept him in the lead for a few more years. But the lack of returns straightened his curve. He ended the 20 years with $100k in savings, and was far behind Lilly and John at that point.
John’s savings started to really benefit from compound interest in the second decade. His savings grew by $91k to $126k. $71k of that growth was in the form of investment returns.
Lilly’s investments really began compounding, passing John and Greg by year 14 and going straight up from there. She ended year 20 with almost $193k, and the more than $161k increase came entirely from investment growth.
“Compound interest is the eighth wonder of the world.”
–Albert Einstein
Now you can see why Warren Buffett is one of the richest men in the world and 99% of his fortune came after he turned 50. His returns looked something like Lilly’s if you smooth them out over the 6 decades he has been investing! It takes a special mind to pull that off and to want to analyze businesses every day for 65+ years.
“My wealth has come from a combination of living in America, some lucky genes, and compound interest.” –Warren Buffett
1.3 Crossover Point: when your investments are working as hard as your savings
The crossover point when your investment returns are more important than how much you are saving depends on three things:
- How much you already have saved,
- your average expected annual returns, and
- the amount you will add to savings in the current year.
When you multiply #1 and #2 together, you get the amount of money that your investments are expected to grow by. When this greater than #3, your investments are working harder for you than your new savings in an average year. For those of you who like equations, it looks like this:
This is what Lilly did to figure out that her expected returns of $6,230 ($31,150*20%) were much greater than her $1,000 in new savings.
John was also at that point in year 10 with $3,506 in expected returns ($35,062*10%) and an annual savings of $2,000. Figure 3 shows where John’s crossover point occurred in year 7, and how his investment returns compounded far beyond that point through year 20.
The example above was simplified to concentrate on a point.
Your investments will not be a smooth curve in reality. And you should be increasing your savings every year as you grow your career or business income.
So your crossover point might not be as early as year 7—for a good reason. You could also have multiple crossover points before your investments far exceed your ability to save. This creates a period of time where both saving and investment returns are approximately equal in importance.
If you are not saving enough, on the other hand, your crossover point can be artificially low. Your target should be to save 15% or more of your income early in life. If you have not exceeded 15% by your crossover point, you still have some work to do before you can be comfortable with your savings trajectory.
On a final note, the crossover point of investment returns and annual savings should not be confused with another concept. The book Your Money or Your Life discusses a crossover point where the income from your investments equals your annual expenses. This crossover point is what PathwayToFI is all about—financial independence (FI)!
2 Summary
The scenarios in this article demonstrated three key points:
- Saving money is more important than investment performance early in life
- This is where you should focus on earning more, spending less, and saving as much as you can
- A simple 100% stock index investing strategy is all that you need here
- Subscribe for free at the bottom of this page or on the contact page to see the PathwayToFI Trailhead/Ascent portfolio, which is great for this stage
- There is a crossover point where your investments are earning as much as you are saving each year
- Compound interest begins taking over here
- When your investments are past the crossover point, investment returns become more important than how much you are saving
- This is where you need to focus on what you are invested in and how it helps you meet your goals
- Poor investment decisions earlier in life had much lower consequences than they do now
Where are you on your investment journey?
Do you know where your crossover point is?
Should you be focusing more on increasing your savings or on investment returns?
Contact me on social media or the contact page to keep the discussion going.
And don’t forget to sign up for FREE at the bottom of the page to get much more value from PathwayToFI.
Join me on the path to FI!
