Importance of saving rate

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Investors often focus primarily on asset allocation, expenses associated with investments (such as transaction fee, expense ratios), tax efficiency (types of account), sector allocation, active vs passive etc, to maximize the return on investment to attain a financial goal. Further, importance of saving early is also well documented to reach the financial goal. In this article, role of savings rate is presented to understand its impact on an investors financial goals. Role of savings rate effect is compared with return on investment.

Savings Rate

Savings rate is defined as percentage of income saved by an individual or entity towards a financial goal.[1]

To put the savings rate in perspective, let us say two investors A and B make $100,000. Investor A, saves 4% of income ($4000) consistently for 30 years, with return on investment on savings at the rate of 6% will have $316,233 at the end of 30 year period. However, investor B saves 6% of income ($6,000) but the return on investment on savings was only 4% will have savings of $336,510 at the end of 30 year period. The increase in savings rate is crucial particularly if the return on investments is low. However if return on investments are very high, then the impact of savings rate become relatively less important. Alternately, if the savings rate is less than 4%, the savings rate has huge impact on the end balance over the rate of return. Example, for savings rate of 1%, return on investment 12% is necessary to save $241,334, whereas, for savings rate of 2%, return little over 8% will suffice to achieve the end balance of $241,334. Table below will help visualize the relation between savings rate and return on investment for given savings rate.

Table 1: Saving Rate (SR) Vs Return on Investment (ROI) for Savings. Assumptions: Annual income: $100,000. Future value calculated assuming money invested at the end of period.

ROI SR SR SR SR SR SR SR SR SR SR
1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
1% $34,784.89 $69,569.78 $104,354.67 $139,139.57 $173,924.46 $208,709.35 $243,494.24 $278,279.13 $313,064.02 $313,064.02
2% $40,568.08 $81,136.16 $121,704.24 $162,272.32 $202,840.40 $243,408.48 $283,976.55 $324,544.63 $365,112.71 $405,680.79
3% $47,575.42 $95,150.83 $142,726.25 $190,301.66 $237,877.08 $285,452.49 $333,027.91 $380,603.33 $428,178.74 $475,754.16
4% $56,084.94 $112,169.88 $168,254.81 $224,339.75 $280,424.69 $336,509.63 $392,594.56 $448,679.50 $504,764.44 $$664,388.48
5% $66,438.85 $132,877.70 $199,316.54 $265,755.39 $332,194.24 $398,633.09 $465,071.93 $531,510.78 $597,949.63 $664,388.48
6% $94,460.79 $158,116.37 $237,174.56 $316,232.74 $395,290.93 $474,349.12 $553,407.30 $632,465.49 $711,523.68 $790,581.86
7% $94,460.79 $188,921.57 $283,382.36 $377,843.15 $472,303.93 $566,764.72 $661,225.50 $755,686.29 $850,147.08 $944,607.86
8% $113,283.21 $226,566.42 $339,849.63 $453,132.84 $566,416.06 $679,699.27 $792,982.48 $906,265.69 $1,019,548.90 $1,132,832.11
9% $136,307.54 $272,615.08 $408,922.62 $545,230.15 $681,537.69 $817,845.23 $954,152.77 $1,090,460.31 $1,226,767.85 $1,363,075.39
10% $164,494.02 $328,988.05 $493,482.07 $657,976.09 $822,470.11 $986,964.14 $1,151,458.16 $1,315,952.18 $1,480,446.20 $1,644,940.23
11% $199,020.88 $398,041.76 $597,062.63 $796,083.51 $995,104.39 $1,194,125.27 $1,393,146.15 $1,592,167.02 $1,791,187.90 $1,990,208.78
12% $241,332.68 $482,665.37 $723,998.05 $965,330.74 $1,206,663.42 $1,447,996.11 $1,689,328.79 $1,930,661.47 $2,171,994.16 $2,413,326.84

In the initial phase of accumulation of wealth, savings rate have the most impact in increasing the nest egg. The return on investment becomes important only after the nest egg has grown significantly or after it achieved a critical mass.[2] To achieve a financial goal, investor have only control on the savings rate than on market returns.[3] Thus to achieve a particular financial goal, savings rate is more important than returns. [4] Morningstar had recommended some suggestions to increase the savings rate.[5]

References