The Savings Rate
This was from a post I made years ago on the Bogleheads forum. It’s still applicable.
The importance of increasing your savings rate
For a “young” investor (meaning one who has a low account balance relative to the amount he will need to retire, say a ratio of 25% or less) his savings rate has a much greater effect on the amount of money he will have to spend in retirement than his return. Rather than focusing on how to eke out a few more percentage of return, he would be much better off focusing on how to increase his savings rate.
An investor with $10,000 who saves $5000 a year expects to have $167,000 15 years from now if he pulls off an 8%/year return. If he can increase that return by 1%, he would have a total of $182,000. However, if he could increase his savings by just $2000/year, he would end up with $222,000. He would get much more “bang for his buck” by saving more rather than trying to get a higher return.
The opposite is true for a “mature investor” (again defined as someone with a high percentage of what he would need to retire on.) Let’s say we have a 60 year old investor with 5 more years until retirement. He has a nest egg of $1,000,000. He is currently saving $20,000/year and expects an 8% return from his portfolio. This will only get him to $1.59 Million. Where is the bang for his buck now? If he saved another $5K/year, he would end up with $1.62 Million. But if he could increase his return by 1%, he would end up with $1.66 Million. Clearly the bang for his buck is in maintaining/increasing his return.
Steps to Increase Savings Rate
The following are some steps you can take to increase your savings rate:
1) Increase the amount of money you make. It is much easier to save 25% of $200K than it is to save 10% of 40K, even while paying a higher tax rate. This can be accomplished by further schooling/training to upgrade your skills, changing jobs when opportunities to make more money arise, and taking additional jobs/working overtime.
2) Save the raises. Cost of living and standard raises are frequent with many jobs. Although we often need to gradually increase our spending to maintain our lifestyles, often times we do not need to increase our spending as much as our income increased.
3) Keep your fixed expenses as low as possible. The less you are obligated to spend, the more you have the option to save. Then you can make conscious decisions between spending and saving each month. Avoid contracts you can’t get out of if your finances turn sour, such as cable, cell phone, boat payments, large mortgages etc. Try to rent your lifestyle when possible, rather than buy it.
4) Beware the Big Two-Your house and your cars are where you can save a LOT of money. Most people calculate out their mortgage payment when they opt for a bigger, nicer house, but they forget that they also have to pay more in taxes, utilities, repairs, landscaping, furnishings, and upgrades on that bigger, nicer house. Because your house is a big ticket item, saving 25% on that will free up much more cash flow than eating out 25% less. To make it worse, most of these expenses are fixed expenses.
Likewise with cars, a great deal of money is lost buying and financing these depreciating assets. The older you buy a car, the less you will pay in financing costs, depreciation, insurance, and sometimes even repairs because you may be less likely to repair unimportant features of an old car, such as dings in the bumper or a power mirror that works poorly. The savings in repairs and gas of a new car do not come anywhere close to overcoming these costs.
5) The Latte Factor- Even small costs can add up over time, especially when considered in light of decades of compounding. The classic example is the $5 latte. If you save that $5 a day ($180 a month, $1825/year) and earn 8%/year on it, it will be equal to $482K in 40 years. Consciously decide what you want to spend your money on, and spend it on that which brings you the most happiness, and save the rest.
6) Calculate your savings rate each year- Studies show that we consciously and subconsciously strive to improve in those aspects which we measure.