By Mike Moody
I harp on savings a lot. It’s really important in building a portfolio. After all, if you don’t save, there is no portfolio to manage in the first place. Mike Patton had a very good article at AdvisorOne demonstrating exactly how important savings is. Here was his test: he assumed that an investor would make an annual contribution of $10,000 to an investment account each year for 20 years. That pool of money would compound at rates ranging from 5-10% per year. Then he stripped out how much of the return was from investment performance and how much of the return was just from the savings. The results are eye-opening, to say the least. The percentage number shown is the percentage of the return coming from investment performance. Here’s the table from his article:
You Need to Save to Grow!
Source: AdvisorOne (click to image to enlarge)
In true miracle-of-compounding fashion, investment performance only starts to overwhelm savings in the out years! All of the years where investment performance are more than 50% of the return are in red, and even when the assets are compounding at 10% annually, it takes more than a decade before investment performance outstrips savings.
Clearly, in the early phases of capital accumulation, savings is much more important than investment performance. Instead of worrying about investment recommendations, you can best help the client by keeping them focused on making regular account contributions. When the regular contributions become small relative to the overall account size, investment performance will tend to be the main driver of growth.
Investment management is most important for clients who have already acquired critical mass; saving is most important for clients trying to get there.