Making Cents: The savings and investment continuum

WHEN DOES it matter or does it matter at all, whether you should focus on the amount you save each year or the returns those savings earn each year?

And the answer is, it actually matters a lot.

Unfortunately, sometimes people make the mistake of choosing one over the other, so I want to look at what area you should devote more of your time to, because everyone will be different, right?

Which is why I want to take a look at each in their own right, and to be honest what I’m going to point out might be very obvious, but sometimes I come across people who spend all of their time and energy focusing only on what type of account they should be saving into.

And from my encounters, that group of people are typically aged between 25 and 35.

When we begin to talk about different accounts, they invariably ask about interest rates and what the best available is, and who it’s with.

It seems to me that some get fixated with the return, as if it's critical to their long-term success.

They believe it’s the most important thing they should be doing, and there’s no doubt it’s important, of course it is, you want to get the best return you can possibly get, but perhaps they shouldn’t over think it as much as they do.

What you should focus on will really depend on where you fall into what’s known as the saving and investing continuum.
Let me explain.

If you are saving €700 per month, your expected savings for the year ahead will be €8,400.

If that same person has a separate €10,000 in savings and achieves a return of 5% over a year, their investment will grow by €500.

When you compare both numbers, it’s pretty obvious which is higher.

They are saving €8,400, and their investment returns are €500, so clearly the amount they are saving is much higher than the return on their savings.

And whenever something like that happens, you should focus your energy on whatever is producing the biggest return for you, and in this instance it’s how much you are saving each month.

If you can increase that amount, it will make a much bigger impact than increasing the % return you get on an investment.

If you increase your savings rate by 10%, you’re saving an additional €840 per year, and that means you’re now saving €9,240 each year.

If you increase your investment returns by the same 10%, you’re adding an extra €1,000 to your savings and a total of €1,500 to your bottom line each year.

When you stand both alongside each other, you can see what’s adding more to your finances, and that’s the amount you can control, which is the amount you can save.

So, if you spend more time concentrating on the amount you spend each month and/or making yourself more valuable to your employer whereby you can increase your income, you’ll have more money to save, and it’s very unlikely that any investment return is going to come even close to matching that.

And that’s because for an interest rate to make any difference, you first have to have a reasonable amount saved, and the interest rate isn’t going to do that for you, the amount you save is.

It’s only when you have a significant amount saved, that the rate of return becomes important, but it's largely irrelevant I would say for the first 5 to 10 years of your savings life, because you’re starting off at a low base.

But, over time as this grows and as you age, your focus will then shift to what your investment is growing by each year and I’m now going to show you why this will happen.

Let’s assume you save €800 per month and you always achieve an annual return of 5% per year.

In year 1, your investment return is €223 but you are saving €9,600 per year. Which means your annual savings are 43 times greater than the annual return from your investment.

If we fast forward 20 years, you will have €328,327 in your account (I’m using the same 5% annual return for each year and the same savings rate i.e. €800 pm) and at this stage, your investment is generating €16,416 in interest each year.

But if you are still saving that €9,600 every year, it means your investment returns are now 1.71 times more than what you are saving. And when that happens you have to start focusing more on your investment returns than on your savings because they are adding more to your net worth than your savings are.

The crossover point in this instance happened at about year 14, because that’s when the returns per year began to exceed the savings per year.

And it’s not all about focusing on how much more you can earn in interest, over the amount you can save either.

Let’s say you have accumulated €200,000 (I’m only picking this number for example purposes) and you are saving €600 per month.

If markets decline by 10% on your investment, that’s a drop of €20,000.

If that was to happen, can you save €20,000 to compensate for this loss?

And the answer appears that you can’t if you’re only saving €7,200 per year.

You’d need to increase your savings by quite an amount to jump to €20,000. And if this wasn’t possible, and your annual savings can’t compete with the reduction in your fund value, that’s another reason why you’d need to spend more time focusing on that €200,000 and where it’s invested, rather than the €7,200 you are saving.

So, if the loss on an investment return is larger than the amount you could expect to save every month or year, then you need to switch the focus and become much more familiar with the account or fund you are saving into.

Eli Lilly launch billion euro Limerick site

And I’m not suggesting you should only focus on saving and ignore educating yourself about the different types of accounts and mechanisms, or vice versa, of course you shouldn’t. But you don’t need to have excel after excel sheet working out complex algorithms about how one fund or asset class performs against another when your savings rate is much higher than any return you can calculate or estimate.

Your time would be better spent uncovering how you can raise your savings rate by 10% than your investment return by 10%, but if you can do both, then great, but as I said, control what you can control and that’s how much you can save.

And if your two numbers are close together, i.e. you save €2,500 each year and your existing savings/investments generate €2,500 in interest, then spend the same amount of time on both.

It’s really interesting to learn that if you take this one step further, by the end of someone’s working and savings life, about 70% of their end number will have come from investment gains, and not the amount they saved.

There’s obviously a big difference between the two, but you can’t have one without the other. You can’t reap the rewards of those gains without putting in the heavy lifting first and saving as much as you can, because they both go hand in hand, it’s just knowing what to focus on and when, that’s all.

Liam Croke is MD of Harmonics Financial Ltd, based in Plassey. He can be contacted at liam@harmonics.ie or www.harmonics.ie