One of my favorite feelings in the world is an epiphany. I’m talking about an “aha!” moment, or a “paradigm shift” if you’re into Stephen Covey.
For me, these moments usually involve some small change in perspective, or a slightly different way of explaining something, which drastically changes the way I view the subject.
It’s like discovering some great secret, except the secret has been right in front of you all along. In that sense it’s like buried treasure: you were probably all over it, you just needed to dig down and find it.
A recent epiphany I had was about personal finance and investing.
Being a financial analyst by training, I often fall victim to the time and energy trap of spreadsheet analysis. If you are decent with Excel and interested in investing, it’s only natural to eventually find yourself analyzing investment return scenarios.
You might be looking at the potential performance of your 401k, IRA, or other investment accounts. These spreadsheet scenarios often include a variable hypothetical rate of return, along with different asset allocations between stocks, bonds, commodities, etc.
You can go down the rabbit hole in a hurry, by tweaking allocation rates, looking up historical index returns, referencing holding fees, and generally adding any other degree of complexity to your heart’s desire.
The goal in all this is to maximize one specific metric: return on investment (ROI), or simply, “returns.”
How much money will I make? How rich will I get by investing my money?
Many of us have heard the traditional rule of thumb when it comes to stock market investing, that the “market” has on average generated returns of about 10% (convenient round number there, isn’t it?).
But we’ve also heard of the individual stocks which in individual years have generated returns many times this amount, so the default mindset is to view ROI as virtually unlimited – as long as you pick the right investments.
If only we can find that secret asset allocation with high reward and low risk, or if we could only find that special stock which is bound to blow up this year…
Sounds a lot like searching for buried treasure, doesn’t it?
What many of us fail to realize is that investment returns have a much smaller impact on our financial goals than we think.
This is especially true if you are like me, and still in the early stages of your career and financial journey.
Some simple math proves this. Let’s say you have $50,000 saved in your company 401k. If you are under 50 years old, you can contribute up to $18,500 in 2018 (plus $6,000 for “catch-up” contributions if you are over 50).
What’s more, whatever you contribute to your 401k is shielded from income tax until retirement, so you are simultaneously saving for the future and on your next tax bill.
If the market (and your asset allocation) has a great year – let’s say 12-no, 15% returns – then your 401k would earn $7,500 for the year.
Let’s go one step further and factor in your contributions at the maximum level (pretty optimistic), and the assumption that all of the $18,500 goes in on January 1st (LOL), thus earning 15% on it’s own as well.
In this scenario, you would earn $10,275 in returns for the year, resulting in a total balance of $78,775 at the end of the year.
Of the $28,775 your 401k grew by from January 1 to December 31, $18,500 of that was your hard earned money. Only 36% of your overall gain came as a result of stellar investment returns. The other 64% came from you diligently putting money aside for retirement.
Only with larger investment balances will the percentages flip.
What is the inflection point, exactly? I’m glad you asked!
Here’s a great graph of exactly what we’re talking about, courtesy of Rick Ferri at Portfolio Solutions:
I love this graph because it goes even further than putting investing and saving on an even playing field.
This illustration actually plays out two different investors and the result of their different strategies (or asset allocations) with separate 5% and 10% investment return outcomes.
The takeaway is that even in a sub-optimal investment strategy (5% annualized return over 25+ years), saving is more important than returns, at least until you’ve built some serious capital (on average, around $230,000 or more in a 401k example).
Conversely, even in an optimistic market environment (10% annualized over 25+ years), it takes DECADES for the lower saving investor to catch up to the lower performing investor!
You could spend all your free time chasing returns and still have grandkids before your account is bigger than your frugal buddy’s.
There’s an important lesson here: until you have about a quarter of a million dollars, forget about your investment returns.
Don’t worry about it.
You have all the control and way more impact with how much you invest.
Plus, you probably have plenty of time before you reach “traditional” retirement age, and you will see plenty of recessions and booms in between.
Chasing an extra few percentage points before the next 30% drop a decade from now is probably a waste of time and energy.
What do you think? Were you as surprised as I was to see how unimportant returns are to your finances in the early going?