There are a lot of investment decisions you could spend time worrying about, but there’s only one that really matters: How much you save is more important than any other part of your investment plan.
It’s more important than the type of investment account you use. It’s more important than the specific investments you choose. And it’s much more important than the many things that are out of your control, such as whether the stock market goes up or down this year.
In fact, all those other pieces of your investment plan barely matter at all unless you first get your savings rate where it needs to be.
Here are three reasons why that’s true.
Reason #1: The More You Save, the Sooner You’re Free
This might sound obvious, but have you ever actually looked at the numbers? Do you know how many more years you’ll have to work at your current savings rate? Do you know how much sooner you could be free with a higher savings rate?
Well, here are the numbers. This chart shows just how long it takes to reach financial independence at various savings rates:
Credit: Mr. Money Mustache. Assumptions: Starting with $0 in savings, 5% inflation-adjusted return, 4% safe withdrawal rate in retirement.
Now, there are a few assumptions here. The numbers assume that you’re starting from $0 in savings, and they don’t account for any Social Security income you might receive.
But no matter what, the point here is clear. Even a small increase in savings can cut years off your working life.
Increasing your savings rate from 5% to 10% allows you to retire 14 years earlier. Increase it another 5% and you get to retire another 8 years earlier.
Or maybe you’d like to get really ambitious, save half your income, and be completely financially independent in just 17 years.
It’s possible, and you don’t have to know the first thing about investing to do it. You just have to do the work to save money.
Reason #2: You Can’t Invest Your Way Out of Not Saving
Saving money can be hard. You may not be making enough money right now to realistically hit some of those higher savings rates. Or you may enjoy spending money and simply not want to make the sacrifices needed to save more.
In either case, you may think that you can make up for a lower savings rate by figuring out how to get better investment returns. That would really be the best of both worlds, right?
It sure sounds good, but it doesn’t actually work.
The truth is that for the first decade of your investment life, the returns you earn, good or bad, don’t actually matter much at all.
What really matters is how much you save. And it makes sense when you think about it.
Let’s say you have $10,000 in savings. An 8% investment return, which is about average for the stock market over the long haul, would earn you $800 over the course of a year. Even a phenomenal 20% return would only increase your savings by $2,000.
You could save more than that just by contributing $100-$200 per month to a retirement account. That’s only a 2.5% to 5% savings rate on a $50,000 salary.
If you bump that savings rate up to 15% on the same $50,000 salary, you’re now adding $7,500 to your savings each year, which is MUCH more than you’ll earn from your investment returns. At higher salaries, the difference is even more dramatic.
The bottom line is this: For the first decade or so of your investment life, saving more has a MUCH bigger impact on your eventual success than finding a way to earn better returns. Focus on getting that part of your plan right before worrying about everything else.
Reason #3: Eventually Your Returns Will Matter a Lot, But…
The flip side of Reason #2 is that eventually your investment returns will start to outpace your contributions. And when you get to that point, your specific investment strategy will matter a lot, since both your gains and losses will have a big impact on your eventual success.
But that only happens once you’ve built up significant savings. And you can only build up significant savings by getting your savings rate where it needs to be.
So first you have to save. If you do that well enough for a long enough period of time, eventually your investment returns will start to matter a lot more.
This Is Good News!
All of this is actually good news for you. It means that most of the confusing, complicated investment decisions you hear about online and in the news don’t really matter that much to you.
You don’t have to have a PhD in finance to be a successful investor.
You don’t have to have a ton of money to be a successful investor.
You don’t have to make all the right investment selections, or use the exact right accounts, or worry about the ups and downs of the stock market to be a successful investor.
All you have to do is focus on increasing your savings rate. If you do that, you’ll be in great shape no matter what the rest of your investment plan looks like.
Matt Becker is a fee-only financial planner and the founder of Mom and Dad Money, where he helps new parents take control of their money so they can take care of their families. His free book, The New Family Financial Road Map, guides parents through the all most important financial decisions that come with starting a family.
Related Articles:
- Seven Reasons You Need to Start Investing Right Now
- Best IRA Accounts of 2016
- Four Ways to Start Investing Without Much Money
The post The Most Important Investment Decision You’ll Ever Make appeared first on The Simple Dollar.
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