Concentrate On Savings First

I wrote this post quite a while ago but when Mr. Cheap published a post on a similar idea (Labour versus Investment Income) yesterday, I figured it was a good time to post it. His post focussed more increasing income rather than investment strategy whereas this post has more to do with savings.

I was talking with my sister a while back about investing and she was asking about some of the types of investments that I own. I am a passive investor and own mostly exchange traded funds. Since she is moving to Asia later this year, she doesn’t have access to the same exchange traded funds that I do and was worried about missing out or not having the best investments. My answer for her was – don’t worry about the exact investments you own – the main thing is your savings. If you spend less than you earn, hopefully a lot less than you earn, then you will be fine. You don’t need to have the absolute best investment plan to secure your financial future.

What are savings?

I define savings as using your earnings to increase your net worth. If you earn $1000 and pay off some debt then you have saved that money and your net worth has increased. Normal savings of course, is when you have the actual cash and can keep it in the bank or invest it. Ultimately your financial security depends on how much money you have – how you got there doesn’t really matter. Whether you invested in bonds, stocks, expensive mutual funds – whatever – that is not as important as how much money you saved in the first place.

Some proof

I set up a little financial model to show the effects of investment return compared to rate of savings. Basically I want to compare one person who save a lot of money but gets a low rate of return with another person who is a much better investor and consequently gets a higher rate of return – but they don’t save as much. The question is who ends up with the most money?

Scenario

Saver Bob saves $10,000 per year and invests in a tax-free account. Saver Bob is very conservative and can’t stand the thought of his investments declining in value so he invests in government bonds which pay 4% per year.

Trader Tim saves $5000 per year and also invests in a tax-free account. Trader Tim is very aggressive with his money and invests only in equities which have a higher expected rate of return compared to bonds, but are also a lot riskier since he can lose money. Trader Tim is a pretty successful and get 8% per year which is double that of Saver Bob’s 4% return.

After 20 years, who has the most money? The saver with the low rate of return or the not-so-good saver with a much better rate of return? The answer is that Saver Bob wins the race by quite a bit. Saver Bob ends up with $320,000 which is 27% more than Trader Tim’s total of $252,000.

Summary

We saw from our example that the investor who saved twice as much but got only half the return, ended up with a lot more money. The point is that you should put more effort into saving money rather than how to invest it. I’m not suggesting that it doesn’t matter how you invest – just that it shouldn’t get the same priority as the saving. Once you have your costs under control and feel like you have maximized your savings, then worry more about things like asset allocation, investments etc.