Steady Saving Tops ReturnsSubmitted by Larry Frank Sr. on Tue, 05/29/2012 - 3:00pmHow do you build wealth? Not by sterling market returns alone. Moreimportant is making consistent investments, starting early. You need toplant the seeds that may then grow later.As you can see on the chart above, someone contributing $6,000annually for 20 years (top, royal blue line) and receiving an average 8%per year comes out the best – investing $120,000 and watching it growto $300,000. Of course, you control contributions and not returns,although the level of risk you choose is very influential.Many investors tell me: “Returns are better than contributions.” Nottrue. A picture is better than words so I graphed a few examples using4% and 8% returns.Saving $6,000 a year every year is better than just saving $6,000 once(bottom two lines). Also, continuing to save is better than stopping (redand purple lines divide at 10 years).
Starting early is better than later. The green line is starting late. Comparethat to the purple line when contributions were stopped at that samepoint. It will take more of your money to catch the green line up with anyof the other annual contribution lines.Yes, higher returns are better. But that is with a caveat. The green lineearned 8% but began too late to get decent traction. Finally, saving a bitmore may be better than reaching for greater returns, which comes withgreater volatility. See the dark blue line, which has the lower 4% return inthis example. It took approximately 13 years of returns to overcome thehigher contribution rate. So saving more in the short term is better thanreaching for returns.Contributions at the outset (those first 10 – 13 years) have the mostimpact on results versus market returns. Note that the lines are all closeto each other early on. Market returns have an impact during later years.But, those later years don’t come unless you’re already makingcontributions in the early years.Moral of the story: Contributions are important. If there are nocontributions, there is nothing to grow. Start early rather than later. Savemore rather than less. Reaching for returns comes hand in hand withvolatility, which serves as a drag on return. Returns come from prudentportfolio allocations.While you can’t control returns, you may design an allocation to havemore or less fluctuation in portfolio value. However, that is somethingdifferent than returns. Return can still fluctuate between (and sometimesexceed) historical returns, regardless of your allocation. Even interestrates on cash change over time.So if it is not about returns, what is it about? What can you control?For retirees, you can control how much you spend. For the not-yet-retired, you can control how much you save, which is another way ofsaying how much you spend. How much you spend determines yourstandard of individual living. Returns should not be a variable you usewhen you plan for how much you need to retire on, or how much youneed once you are retired.Don’t chase returns. A prudent plan establishes an ability to capturereturns from key asset classes. But a prudent retirement plan, whetheryou are pre- or post-retirement, should not depend on return calculationsto determine how you are doing. What is more important is measuringwhat you need (for not-yet-retired) or what you have (for retirees).The best returns often come from the asset class that most people shun,not the one most people chase. Why? A price run-up requires someoneelse to pay more, known as the greater fool. Eventually, no fools are leftand prices collapse. The prudent investor recognizes this and sellsportions of rising assets, then puts the proceeds into portions of fallingassets. In other words, rebalancing.
When I was an Air Force pilot, we practiced emergency procedures in thesimulator every year. We did things that you couldn’t practice in theaircraft or didn’t think about most of the time. Like what to do in anelectrical fire, or if the hydraulics or an engine fails. Why practice? Todevelop habits that override your natural, fearful responses in case theunexpected happens. That same discipline through market simulationsmay bring thoughtful responses when the markets are fearful.Note: Returns are not reflective of any particular investment and arepurely hypothetical. Returns do not reflect higher volatility that is oftenassociated with reaching for higher returns, and vice versa. Market returnsmay not always be positive and may result in loss.Larry Frank Sr., CFP, is a financial advisor in Roseville, Calif. He is theauthor of the book, Wealth Odyssey, and has peer-reviewed researchpublished in the Journal of Financial PlanningAdviceIQ delivers quality personal finance articles by both financialadvisors and AdviceIQ editors. It ranks advisors in your area by specialty.For instance, the rankings this week measure the number of clients whoseincome is between $250,000 and $500,000 with that advisor. AdviceIQalso vets ranked advisors so only those with pristine regulatory historiescan participate. AdviceIQ was launched Jan. 9, 2012, by veteranWall Street executives, editors and technologists. Right now, investorsmay see many advisor rankings, although in some areas only a few areranked. Check back often as thousands of advisors are undergoingAdviceIQ screening. New advisors appear in rankings daily.Topic:InvestingStocksAsset Allocation