A By-The-Numbers Look at Why Saving Is More Important Than Perfect Investment Choices

Share Button

About once a week, I’ll get an email from a reader along the lines of this recent one from Leo:

I don’t know how to invest. I don’t know what to invest in. So I keep putting it off because I’m worried about messing it up. It’s ridiculous that this is all so complicated.

The path to financial success really isn’t that complicated, Leo, especially when you’re starting out. Your investing choice doesn’t matter much at all at first compared to the importance of simply saving that money. It’s only (much) later on that optimizing your investments really matters.

Doubt it? Let’s say the stock market returns 9% in 2009. You have three options – an investment that will end up only returning 7%, an investment that will end up returning 11%, or fear and procrastination.

If you elect to save just $10 a month and put it in the good 11% investment (compounded monthly), you have $125.40 at the end of the year.

If you elect to save that same $10 a month and choose only the 7% investment (again compounded monthly), you have $123.80 at the end of the year.

Yes, the difference between the great investment and the awful investment is only $1.60. Not much, huh?

Well, let’s compare it to fear and procrastination. That ends up with $0 in your investment account. Compare that to the “worst case” above, where you have $123.80. The “best case” is only $1.60 more than that.

Even if you’re investing substantially more, the difference isn’t that tremendous. If you’re socking away, say, $250 a month, you’ll have $3,095 in the “worst case” and $3,135 in the best case – a $40 difference. With fear and procrastination, you have nothing at all.

Even more impressive, waiting just one month costs you dearly. If you start investing now in the 7% investment as compared to waiting just one month and then starting in the 11% investment, it will take 33 months for the “good” investment to catch up in returns. Wait a year and a half and you’ll likely never catch up.

If you’re just starting out, a relatively poor investment doesn’t matter much at all. What matters is that you’re saving and building up the principal.

If you’re still afraid to take that leap and get your 401(k) or Roth IRA set up because you’re afraid of choosing a bad investment, do it as simply as possible. Choose the broadest investment you can so that you’re essentially in the average of all investments. For example, if you’re opening a Roth IRA at Vanguard, just invest in the Vanguard Total Stock Market Index – you’ll be invested in all stocks and will go up and down with the market as a whole. If you did that in the example above, you’d be right in between the worst and best investments – doing right what the market does – without any worry or research.

Remember, though, starting now, even in a relatively poor investment, is far, far better than being afraid and putting it off. Don’t let fear and procrastination rule the day and keep you from retiring later on.

Share Button
The Best Bank Rates
Loading Disqus Comments ...
Loading Facebook Comments ...

35 thoughts on “A By-The-Numbers Look at Why Saving Is More Important Than Perfect Investment Choices

  1. My once-young nephew put aside something like 10-15% of his salary for the first 10 years of his working life! It served him well – and he doesn’t even invest in the market.
    Go figure – literally.
    ~Mad(elyn) in Alabama
    http://www.xanga.com/madewyn

  2. Time value of money is one of the eight wonders of the world. It should be mandatory learning, with its own separate class, in every junior high and high school.

    Another impressive book that helps with the understanding of the importance of this topic (investing and saving) is “The Richest Man In Babylon”. It is a classic…

  3. Trent,

    There are several high-yield checking accounts out there (ing orange, charles schwab, fidelity…) that are combo’d w/investment accounts.

    You’ve stated that you like the ing account only if you’re investing in single long term stock investments. is there one that you would recommend as an all-in-one or is it better to go ala carte (vanguard and ing, local bank and another investment bank)?

    Thanks in advance.
    Joe

  4. Hi Trent,
    Your calculations make sense and it is true that savings is certainly important.
    I prefer to investing dividend paying stocks and mutual funds. The reason is very simple and that is cash flow. I enjoy receivieng cash dividends that I can either choose to reinvest or spend as I see fit.
    The beuty of investing for dividends is to find stocks and ETF’s taht increase their dividends year after year at a great er rate than inflation. That way, regardless of the principal value of the investment, you get a raise in income from the investmetn with each passing year. Often times the increase in dividend income can be greater than inflation, which means you are getting richer!
    These stocks and ETF’s are not hard to find. Search for Dividend Aristocrats and Dividend Achievers and you will find a long list of stocks with dividends that increase year after year.
    -Tyler

  5. What is one wants to guarantee that the money isn’t going to be lost? That leaves one with CDs and savings accounts, which pay in the 3 percent range.

  6. Trent. Perfect advice for a novice. Start saving now, make it automatic, make it easy, and make it safe. Then go about educating yourself, remembering to never invest in something you don’t understand. This site is a wonderful resource for learning, in addition your book reviews point to the best books to self-educate.

    I started with Personal Finance for Dummies, then read Mutual Funds for Dummies. Those two together with the pamphlets from work enabled me to feel comfortable to allocate my 401K. Then I moved on to Vanguard’s wonderful website where they lead you by the hand to understanding what an IRA is and what the different IRAs are. It was painless setting up my Roth Ira with them, and yes, the first account I opened was their Total Stock Market Index Fund.

    My action goal this year are to open an international fund with Vanguard in my Roth, having studied them and come to understand the risks last year.

    My learning goal this year is to understand EFTs.

    I take my time, learn, and understand. My dad had a pension and saved nothing. The rest of my family has nothing saved at all and will depend on social security and/or just keep working.

    It is hard starting from nothing with no one to act as a mentor and very easy to fall into get rich quick schemes.

  7. I have been seriously saving since January 2007. I am a single gal, saving to purchase my own home some day (note: I have other goals, I want to live and work in UK from mid-late 2010 for two years, then come back to buy my house). I can not believe how much I have saved in this short amount of time!

    At the moment my savings are attracting a healthy 7.95% interest rate in ING (note: I’m from Australia). I could easily transfer to another high-interest account which offers around 8.15% return, but won’t simply because a) ING has been changing its variable interest rate upwards to keep competitive with the other high-interest online accounts available here, and b) ING has really good online security, the other providers I don’t know about their security, but its not worth the risk for those extra few dollars in interest I would earn with them.

    The return rate from the Aussie sharemarket isn’t so good at the moment (in terms of short term, long term it is okay) – but I do hope to start dabbling in blue-chip shares as well soon.

    In January 2008, I started keeping track of my “Latte Factor” as well, which is now currently standing at over $1100 saved. I hope to use this money to go on holiday to Thailand/Cambodia/Vietnam/Laos at the start of next year.

    Our superannuation system is different to the US. We get super automatically taken out of our pay.

  8. Just to complicate things a little bit – many of the mutual funds where I’ve had my investments have had negative yields for the last 12 months. Which means there’s less money in there now (to the tune of as much as almost 20% in one fund) that I had in there a year ago. In fact, there’s less money in there now than I put in there three years ago when I transferred money into it.

    But even with that caveat, your advice is sound. Even just stashing the money under your mattress (where it is sure to lose value, due to inflation) is better than nothing at all. Sure, you may have no idea where the “best” place to put it right now might be. But five years from now, when you have some real value in your retirement account or whatever, you may not only have some better ideas of where to invest, but you’ll also have some real money to do something about it.

  9. I agree with Trent, in the beginning it is the important that you put money aside. But “what you do with it and when” does matter.

    Before you look at 7% or 9% stocks or mutual funds, make sure you have 6 months to 1 year of liquid cash or cash-equivalent. That means you must have a pool of cash to draw on for emergency, such as loss of jobs or can’t work due to illness.

    After you have emergency cash, you can take more risk, such as stocks and mutual funds to get 7% to 11% returns people talked about. These returns are not straight lines, in some years they will be -22%.

  10. Hi Trent,

    I had some inheritance money from a great aunt in a mutual fund (to the tune of about $6000) when 9/11 hit. I lost everything (down to just a couple hundred dollars) and that has made me increasingly hesitant to invest my money again. It’s not necessarily fear and procrastination, it’s fear of losing big. I come from a poor family and $6000 represents a HUGE chunk of money to me! So how does one overcome the fear of losing big AGAIN when deciding where to invest? You can say that 9/11 will never happen again, but who really knows? What would you advise in this case?

    P.S. Might I add that many people try to save enough just to make the initial jump and begin investing, and find it very difficult to get there? I’m talking about a lump sum like $1000 to just start investing. I’m just trying to get my emergency fund covered, then to save another chunk to invest, all the while paying off about $12,000 in credit card debt and $29,000 in student loans. I’m not a big spender but I simple don’t make enough money to get ahead quickly. It feels like a no-win situation, and that’s sort of depressing!

  11. At this point I think 9% (or 7%…or 5%) would be extremely optimistic for this or next year’s stock market. I hope I’m wrong. Right now my checking account is earning a lot more than my Roth IRA.

  12. Trent, can you explain how compounded interest in an investment should be calculated? It’s simple enough in a bank account – the bank pays monthly interest, at a rate of roughly APY/12. At 3%, each $1,000 earns $30, or $2.5 per month.

    But if I’m aiming for an 8% return in the stock market long-term, should I calculate that return on an monthly or annual basis? Does it really matter?

    I’m thinking that the monthly compounding would result in a higher “yield” on paper, making the annual compounding a more conservative calculation.

  13. Waaaait a second: Let’s change the example slightly.

    Starting amount: $100,000

    Time period: 20 years

    Final savings for 7% per year increase: $387,000

    Final savings for 9% per year increase: $560,000

    I.e., 45% better return for the 9% figure. Percentage points matter over the long term, hence the arguments re: Social Security’s future revolve around 1 or 2% increase in returns.

  14. I agree too many people procrastinate for fear of losing.

    But the “worst” situation you presented isn’t worst. Even if the stock market gains 9% in 2009, you can lose up to 100% in 2009, depending on what you buy. There are companies that fail every year, and no one can predict which one. Remember Enron?

    I assume you are trying to say it doesn’t matter very much if someone invest in a Vanguard Total Market Fund or a Balanced Fund, but

    Investing choice does make a difference.

  15. Brian,
    You make a very good point. The larger the sum, the more difference a percentage point makes…that’s how we get in trouble with our mortgages.
    Anyway, Trent is using small figures in his examples to prove that we don’t have to have the “perfect” investmetn before we start saving.
    This post is aimed toward the “beginner” saver.

  16. Very excellent point! I’m always amazed how much work it takes to convince newbies (kids just out of college) how important it is to contribute to the 403b at work.

  17. Brian — I think the point was that if the new investor gets all freaked out about the $200,000 he is going to lose if he doesn’t get it right immediately, then he will be less likely to plunge in and start saving. Better to start investing and worry less about getting the perfect investment from the start. I assume the investor will take less than 20 years to learn something about investing and be ready to make a move to increase his return.

  18. So I’m trying to figure out how a 7% return can be considered a bad investment? Last year, after months of study and reading every web site I could find, I put $20K in an S&P500 low fee mutual index fund. How could I lose ?

    Track the S&P since then and you have the answer – I’m more like -20% today. So far, my t-bill accounts are getting larger by the month though. You pay your money and you take your chances – but the people who hesitate are not necessarily being left behind.

  19. Fortunately Leo has picked the perfect time to procrastinate what with all the plummeting.

    What I did when I was chicken was to think how much money I could lose without missing it. I decided the answer was $60/month. So I contributed, I think, $75/month to my 403(b), which was $60 after taxes. I figured no matter what happened, it would be okay.

    Later I decided that although you actually can lose all your money if you are invested in a single stock or, perhaps, even in a single industry, you are not likely to ever lose more than half your money if you are well diversified.

    And then I realized that a lot of people who were whining about their tech stocks getting cut in half had first watched them double many times. So if your money doubles three times and then–horrors!–gets cut in half, you’re still fabulously ahead. And those kinds of big drops are most likely to happen in very volatile stocks.

    I totally agree about the benefits of starting small and perhaps learning a few things the hard way on small sums of money so that by the time it really starts mattering, you’re pretty confident in your choices. Once you live through a big market drop (for you: the next one), you’ll have a better idea of how well you tolerate “risk” compared to how well you hope you will tolerate it, and then you can make better decisions.

    I am extremely risk averse, but I still invest in stocks (to reduce inflation risk). I recommend as much diversification as you can think up. Yes, yes, stocks and bonds. Domestic and foreign. Small-cap and large-cap. Regular and inflation-indexed. Across all industries. But also (later) look into REITs, paying off a house, building job skills, etc.

  20. “Your investing choice doesn’t matter much at all at first compared to the importance of simply saving that money.” Trent, this is huge. Consider a post where you just repeat the above quote 50 times to make sure everybody gets it. For goodness sake, if you’re just starting out, stick you money in an S&P 500 fund while you spend the next year reading up on investing. That’s what my sister did last year, and she’s so glad she did. I’ve got about 15 funds ranging from REITs to emerging market to value funds, but I’ve been at it for almost 20 years. If I were just starting out, Vanguard or Fidelity’s S&P 500 or Total Market funds would get my money.

  21. There is one caveat to this excellent advice: some retirement plans include restrictions on how often you can trade. So it makes sense to be sure you’re at least in the ballpark of a good choice- something low cost, preferably an index. If your research leads you to decide you want to change to something else but you have to wait until next quarter to make the trade, and least you aren’t wasting a lot in fees over that time.

  22. I think that a novice who is intimidated by all the investment choices out there is best off starting with a savings account, then moving to a few CDs, then to a money-market fund.

    Yes, stocks pay more over the long run. But if you’re just starting to try to get in the habit of saving– then watching your savings *loose* money might spook you right back into spending what you have, so you at least get something for it. At best it would be incredibly discouraging.

    Once someone has gotten in the habit of putting money away every month, and as learned the joy of *earning* interest (however minuscule) rather than *paying* it every month, then they can ease into more aggressive investments for their long term money.

    The risk of getting spooked, discouraged, or intimidated is greater to a newcomer than an underperforming “too-safe” investment is, methinks..

  23. Great advice…but..
    one line I would have added…
    Follow this excellent advice if and ONLY IF you are debt free. Pay off all your credit cards and mortgages first THEN invest.
    Other than that, Great Article!

  24. No offense intended, but I think you should put the shoe on the other foot…

    As an I.T. consultant, I develop custom software solutions. What I do seems exceedingly easy to me. It may be quite indecipherable to you. I always fear that if the clients ever realized how easy it is, I’d be out of work. However, the clients never do and I don’t know why…

    Just to be a competent (not necessarily successful) investor in stocks, bonds, funds is wholly indecipherable to me. “Buy low, sell high” may be good advice, but it sort of glosses over the “investing” education that is required to leverage that advice.

    I have a 401k and lack the slightest idea how to judge the available funds. I had to apportion where my contributions go, so I picked 5 funds that spanned the range of risks that were listed. My contribution is split evenly among those 5 funds (20% each). Somehow, I still sloooooowly bleed money over time. The only reason the balance rises is because I auto-contribute more than it loses… and that chaps my behind.

    All I’m saying is that when clueless investors like myself read articles like yours, it can be a bit frustrating. I did get a chuckle with your investor’s dilemma of having to choose between two different positive rates of return. From my perspective, it’s been a complete crap-shoot and the overwhelming fear is choosing which negative rate of return (from the gazillions of funds available) will do the least amount of damage. If only my 401k would allow me to put my money in an ING “Orange Savings” acount. My daughter’s savings account with ING does better than my (ahem) “professionally managed” 401k account with BB&T.

    I think the problem for me is information overload from all the differing funds to those worthless “prospectus” pamphlets that would tax the comprehension abilities of a New York lawyer (spit!).

    Bleh… It wears you down after awhile.

  25. @ Aaron (#28)

    Your advice suggests that compound interest is unimportant, so I have to reply that you are TOTALLY wrong about demanding that all debts are paid before investing. Yes, the longer one has debts, the worse they are, and they should be paid as quickly as possible. However, compound interest gains over a long period of investing provides many times the benefit over carrying debts for a few years while starting to invest. At the very least, everyone should invest in tax-deferred plans that have matching funds BEFORE even worrying about any debt repayment. Slow and steady wins the race, but you’ve got to get started moving first for that to be true.

  26. Go to Vanguard’s site and plot the performance of the Prime Money Market Fund and Total Stock Market Index Fund. For the 10 years ending June 30, the money fund has a superior total return — and, of course, with MUCH less risk. Amazing.

  27. Trent, I enjoyed your article but it looks like you computed your returns incorrectly. I used the financial calculator @ http://www.arachnoid.com/lutusp/finance.html

    For the 11% compounded annually for a year I used the following values:
    PV = 0
    FV = blank
    Number of payments = 12
    Payment amount = -10
    Interest rate per payment = 11%/12 = .91667%
    Payment at end

    Then click on FV and you get $126.24.

    Then using interest rate per payment of 7%/12 = .58333 you get $123.93.

  28. The thing is… what if the market goes down?
    When you are looking at -10% return on stock market, and -8% best and -12% worst investment, you kinda want to procrastinate a bit keeping money in cash :)

  29. Keep in mind that when you go into the market to invest, you are going into a shark filled pit where other people are trying to get over on you. There IS no easy answer to the investment question because basically when you invest money you are trying to get over on someone else while they are trying to get over on you. It’s that simple.

    That being said, if people saved 30%-40% of their income from day 1 they wouldn’t need to invest for return, as the savings alone would tide them even with the most conservative (dividend-yielding) investments.

    Most people should count on having to SAVE the money they need later and not rely on investment returns to get them there.

  30. If you are worried about a 10% or 20% drop in your holdings then you do not have the right mindset to be investing that money in the first place. When you invest money in stocks, be prepared to eat and endure paper losses. If you aren’t you are just an accident waiting to happen, financially.

Leave a Reply

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <strike> <strong>