Wealth Is Created by Saving, Not Investing
Executive Summary
A large part of the financial services industry is built around investing and focusing on investment returns. But are investing returns the most important personal finance area to focus on for a lawyer? For young legal professionals it’s much easier to increase your savings rate than your investment returns. It also lays out how saving more can actually beat a better investing strategy. Even a small increase in your savings rate can have a huge impact on your financial future.
Why do we save and invest our money?
Investing converts income that took time and personal labor into ownership of an asset. If you buy a stock, you are purchasing a unit of ownership of that company. Today many of the largest companies are operating 24/7. So even when you are not billing hours, the companies you own are still trying to make money.
The stock market allows you to buy and sell ownership of different companies, collections of companies, and other assets like property. Every day these pieces of ownership (assets) are traded, and the market determines a price for each. Every time the price changes, the return on the value of your ownership goes up or down. Throughout your life, some assets will go up while others will go down. Some will go “to the moon” and others will come crashing down.
Ideally, we would only own assets that go up and go up quickly, but this is nearly impossible to do. So if we cannot control the future returns of our assets, what can we control?
How much we own!
Ownership = Freedom
If you won the lottery today, what would you do?
We all have a unique idea of how our life would look. Yet nearly everyone’s answer includes that they would no longer have to do things they do not want to do. If you do not like to do laundry, you could pay someone else to do it for you. If your job stops you from traveling to a new country for two months, it will no longer matter. You can take the trip and not worry about the upcoming rent or mortgage payment.
That is because money gives us freedom. Freedom to do what we want when we want.
To have financial freedom, you need to have enough money to pay for your lifestyle and the time to enjoy it. As stated above, a salary requires your time and labor. Depending on the assets you own, ownership of some assets does not require time or labor.
So if you want to be financially free, you need to own enough assets to afford your dream lifestyle.
The more your assets grow in value, the quicker you can have financial freedom.
For a portfolio of owned assets to grow, at least one of two things must happen. First, you can create growth by buying more assets. Second, your assets can increase in value.
Returns matter more to those who do not save
Historically, financial advising centered around investing the assets of the wealthy and the retirees. Why?
Originally financial firms made their money from selling investment products. Each time someone bought a stock or a mutual fund, the firm that executed that trade would charge a fee. Part of this fee went towards a commission payment. Commissions made it less appealing to serve people with a low net worth because they could not generate the commissions that wealthier clients could.
A fee model named Assets Under Management (AUM), where a financial professional earns a fee based on a percentage of your investable assets that the financial professional manages, is more common today. This fee model also makes it less appealing to work with low net worth individuals because a small percentage fee of a small number of assets does not generate enough revenue to sustain a business.
These fee structures built around investable assets caused the industry and the public to focus on investment returns. How much an investment’s value increased or decreased was important to clients of these professionals. Couple that with the fact that when we retire, we no longer have an income to save. So a retirement portfolio has to fund a retirement that possibly spans decades without receiving any additional contributions. The result is an industry that focuses on investment returns over savings rate.
Investment returns are important, but are investment returns more important to a young lawyer than a high savings rate?
The answer is: Probably not.
What is a savings rate?
The savings rate is how much of your after-tax income is saved and not spent. If you make $100,000 after taxes and save $10,000 to a 401(k), plus you put an additional $5,000 in a bank account, your savings rate is 15%. If you only contribute $3,000 to a 401(k) and spend the rest on your living expenses, your savings rate is 3%.
What are investment returns?
Investment returns are how you measure the change in the value of an investment. In a simple example, if you buy a $1,000 asset and in a year, the asset is worth $1,080, then your annual investment return is 8%. If it is worth $1,090, then the annual investment return is 9%.
Can you control your investment returns?
To some degree, yes! The investments that you choose to own have a direct impact on the future value of your portfolio of assets. If you decide to invest in safer assets, likely, your safer assets will not grow at the same rate as other assets. Likewise, if you decide to invest in riskier assets, you may end up with more or less than if you had invested differently.
This blog is not about how you should invest your money. Instead, the rest of this blog post will assume that you will have the same investment returns regardless of how much you save or much the assets are worth. We cannot control how investments perform in the future, but we can decide how much we save and invest. So let’s focus on what we can control.
How Often You Save Matters
How often are you contributing to your investments?
If you have a 401(k) at work, maybe you are contributing every paycheck.
If you do not have an employer retirement plan, maybe you contribute once a year when your annual bonus comes in.
Is contributing once a year better than contributing every two weeks?
Let’s take a look:
Example: You earn $100,000 per year after taxes, and you want your savings rate to be 10% for the next 30 years. If you contribute annually, you will invest $10,000 immediately. If you contribute every two weeks, you will contribute around $385 per paycheck.
But you are not just saving your contributions. Instead, these contributions invest into different investment options. For this example, we will use a hypothetical 8% annual investment return for all of your portfolio.
After one year, the annual contribution of $10,000 would grow to $10,800. Meanwhile, the "every two-week" contribution would be $10,426. So after one year, you would have been better off contributing $10,000 at the beginning of the year because it allowed the entire $10,000 to grow by 8%. Meanwhile, the other option resulted in only 1 $385 contribution to grow at 8% for the year. The next $385 contribution would have only grown at 8% for 50 out of 52 weeks and so on.
So it seems like contributing at the beginning of the year is the best way to contribute, right?
Wrong!
While it may have resulted in a greater value initially, over 30 years, the results flip. After 30 years of contributing $385 every two weeks, the final portfolio value after 30 years was $28,210 more than contributing $10,000 annually. Overall, it resulted in over 2% more value than one contribution at the beginning of each year.
Now a 2% difference is not a significant outperformance but over a long enough period, contributing more frequently results in more value holding all else equal.
How much you save matters
A common rule of thumb in personal finance is you should contribute enough to your 401(k) to get the full employer match. While this advice is rarely ill-advised, just contributing enough to get the employer match is insufficient if you are trying to save enough for retirement. Instead, young lawyers should aim to save 10%-15% of their pay, including the employer match.
How much does your savings rate matter?
If you are considering a 3% savings rate, you should know that increasing that by 1% to a 4% annual savings rate will result in 33% more money in retirement if all else is equal.
If you are considering a 5% savings rate instead of a 15% recommended savings rate, you would end up with 66% less money in retirement savings if all else is equal.
Arguably a small increase in your current savings rate will not meaningfully affect your current lifestyle, but it will make a huge difference later in life.
An easy way to increase your savings rate is to increase your current savings rate each year if you receive a raise. If you receive a 4% raise next year, consider raising your savings rate by 2%. You will still have 2% more income, but you will also increase your savings rate. A win-win!
A higher savings rate can beat a better investment return
Now that we see how contributing more frequently will outperform over a long enough time frame and that increasing your savings rate will help you achieve a higher net worth, all else equal, we need to see how savings rates compare to investment returns.
Please note that all of these are hypothetical returns and savings rates and do not reflect your unique circumstances.
Let’s say we are deciding between saving 3% and 5% annually for the next 30 years on an after-tax income of $100,000. If the 5% savings rate only grew at 5% annually, the 3% savings rate would still end up with less value after 30 years, even if it had a 7.5% investment growth rate. In this example, a 2.5% better investment rate would not outperform a 2% greater savings rate.
But neither of these savings rates would satisfy the 10%-15% savings rate rule of thumb mentioned above.
So what if we choose between a savings rate of 10% vs. a 15% savings rate. If the 15% savings rate grew at 7% annually, the 10% savings rate would need to achieve roughly a 9% annual investment return to equal the 15% savings rate with a 2% lower investment return.
Finally, let’s take this to an extreme. Let’s say we are deciding between a savings rate of 3% or 15%. The 15% savings rate grows at 7% annually. Even if the 3% savings rate grew at 14%, double the investment return rate of the 15% savings rate, it would still underperform the 15% savings rate at 7%.
While these examples show how a high savings rate can outperform a better-investing strategy, it does not mean that a high savings rate will always outperform any investing strategy. In general, the greater the difference in savings rates, the greater the investment return difference needs to be in order to match or exceed the higher savings rate strategy.
As stated above, we cannot control our future investment returns. We can create a portfolio that should do well over a given period, but we will not know how well it will do in the future.
Contrary to investment returns, we do have control over our savings rate. Making a conscious decision to set a high savings rate will likely result in more wealth than a lower savings rate with a similar investment approach.
So how can you increase your savings rate?
Avoid lifestyle creep
Lifestyle creep is a term to express when your expenses increase as your income increases. As your expenses increase with each raise, your total monthly expenses will continue to grow to the point that you will not be able to leave your current job or afford to be laid off without being unable to afford your lifestyle.
Lifestyle creep can lead to the exact opposite of financial freedom.
Yet some lifestyle creep is good. You do not have to live like you lived in law school. You worked hard to earn the high salary of a lawyer. Live a comfortable lifestyle!
The distinction is to live a life you can afford but not at the expense of your future financial freedom.
The best tip to control lifestyle creep is to pay yourself first. Set up an automatic transfer on your paydays to automatically transfer a certain percentage of your paycheck to an investment account. Then the remaining income can be used to pay for all the things you currently want or need.
Focus on your savings rate and not your investment returns
The financial services industry has a lot of professionals whose sole job is to beat the market with higher investment returns.
The problem?
Even these professionals struggle to beat the market. Over 20 years, only about 14% of domestic stock funds beat the market.
It is difficult for someone to consistently earn higher investment returns than the market as a whole. It is much easier to increase your individual savings rate.
So which one would you choose to improve?
Work with a financial planning professional
The future is uncertain, but financial success favors the prepared. A financial planner is a financial professional who specializes in planning for the uncertainty of life.
Working with a financial planner will allow you to see your entire financial situation. Once you see it all together, the financial planner can guide you towards improving your annual savings rate as well as appropriately investing your money.
Both will improve your chances of achieving financial freedom so you can live the life you have worked so hard to live.
That seems like something worth saving for.
Did this blog inspire you to improve your savings rate? As a young lawyer, implementing a saving and spending plan is a key component of the Developing Financial Process. Young lawyers are in a unique position to consistently save and still have enough money to live the life a lawyer deserves to live. Take a step towards confidently making financial decisions that affect you today and in the future. Schedule a complimentary Meet & Confer meeting today with a financial professional who will work with you to develop a plan to increase your savings rate.
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.