Fast-rising investments are the talk of the town. One day it’s GameStop, the next it’s Bitcoin, tomorrow it’ll be something else. Heck, even Hanes stock increased by 25% earlier this week. Everywhere you look it seems like someone is telling you how to double your money. These returns are all attention grabbing, but if you’re just getting started, this shouldn’t be your biggest concern. When you’re first starting your investing journey, your contributions have the biggest effect on your portfolio–not the returns. Let me show you what I mean.
Being Small is Good
When you are first starting off, your investment portfolio will likely be small. That’s perfectly fine. I started with just pocket change on the Acorns app before managing my own investments. Being a small investor allows you some advantages that you don’t have as a large investor. When you’re a small investor, you have more control over your portfolio value than any large investor does.
An investor with a $1 million portfolio and an expected return of 7% will see his portfolio double in roughly 10 years. An investor with a $1,000 portfolio can double their account in a matter of months. Small investors can increase the size of their account by saving more money and contributing to their portfolio. Large investors can’t do this. Someone with a $1 million portfolio would take several years (or decades) to save an additional million.
The large investors must focus on investing returns in order to increase the value of their account. The difference between 7% and 8% for a $1 million portfolio results in a difference of $191,000 over ten years! That’s a lot of moolah.
So if saving is most important to the beginner and returns are most important for the large accounts, when do you shift your focus from saving to investing?
Where’s the Line?
In order to determine this, we need to make a few assumptions. For starters, let’s establish our baseline savings rate and investment returns. According to the Social Security Administration in 2019, the average salary of an employee in the United States was $51,916. With a 20% tax rate, we’re left with a take-home pay of $41,533. If you save and invest 20% of that, you’d contribute $8,300 a year or $692 a month. In the interest of conservatism, let’s drop that down to $500 a month–$6,000 a year.
The S&P 500 has returned an average of 8% per year since 1957. This seems like a safe assumption.
Now that we have our assumptions, let’s check out the results.
We can see that contributions make the largest difference up until $75,000 when it starts to flip towards investment return.
Let’s see how it looks with a savings rate of $700 per month.
With a higher savings rate, the focus remains on savings longer. Investment returns don’t take over until after the $100,000 mark. If we drop the investment return down to 7% and keep our $700 per month saving rate, things get even more interesting.
In this case, the breakeven point is closer to $125,000.
These three charts suggest that the focus should be on saving money until your portfolio reaches a value of $75,000 to $125,000 before the returns start to take over.
But what if you could save more money? What if you could get a better return? Which one would make more of a difference?
Let’s look at a $100 per month increase vs a 1% return increase.
Nearly the same results as the last chart. If your portfolio is lower than $125,000, your focus is better spent on saving money rather than finding extra return.
Just Getting Started
While $125,000 is a great start, it is far from the goal. If we want to be financially independent, we’re going to need much more than that. Let’s say your FI number is $1.5 million. What should be done from the time you hit $125k until you get there?
The smart money is on safely maximizing return.
If you have $125,000 and expect a return of 8% every year while contributing $700 per month, it would take you over 24 years to reach $1.5 million. That’s a long time to wait.
If you manage to increase that return to 10%, suddenly your 24 year goal drops to 20 years. With a 15% return, your retirement goal drops to 14.5 years.
Warren Buffett boasts an compounded return of 20% in his career spanning seven decades! If you could achieve this 20% return as well, your $125,000 plus your $700 monthly contribution would turn into $1.5 million in only 11 years. That’s pretty amazing, isn’t it?
On the Flip Side
The downside of reaching for returns is that you might not get there. In fact, you may end up doing worse than the S&P 500 index. Many professional money managers don’t beat the market when you consider their fees. If you end up getting 6% instead of 8%, your 24 year goal from above becomes 30.5 years. If you only hit 4%, make that 41 years.
In the end, none of this is an absolute guarantee–not even the 8% average return. From July 2000 to February 2013, the S&P 500 was completely flat. Index funds in the S&P 500 would return 0% over these 12.5 years. Japan’s streak is even longer. It only recently reached its levels from 1990. 30 years of 0% return.
The good news is that the market will likely experience a positive return with a long enough time horizon. And even if the market is flat, there are gains to be found in individual stocks if you’re willing to look for them.
The best way for a small investor is to save more money. For a large investor, getting a higher return gets you to retirement faster.
Either way, saving money and managing risk is important. Retiring won’t be easy if you gamble all your money away.
Thanks for reading!
Featured photo source: Shane on Unsplash
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