Financial planning dilemma: To save more or to chase higher returns?

Dev Ashish

When you decide to invest, it’s to earn high returns. Right? At least that is how most people look at investing.

Saving more, on the other hand, is seen as a difficult thing. Why? Because for most people, after all their expenses, not much is left to save. So how can they even think about saving more?

But this is the problem that most people are unable to get a grip on.

Everybody wants to go to heaven. But no one wants to die.

So when it comes to creating wealth, it is extremely important (at least) initially to focus on saving more rather than getting high returns.

A dilemma

Let’s take a small example.

Suppose you and your friend decide that it is the right time to begin investing. Both of you earn Rs 10 lakh annually. And the income is expected to increase by 10 per cent every year for the next several years.

But there are a few differences.

-You decide to invest in products with high return potential (12 per cent), while your friend opts for safe products offering 8 per cent returns.

-You begin to invest 10 per cent of your income while your friend deploys 20 per cent of his income. You chose a smaller amount since you plan (& hope) to generate higher returns than your friend.

Both of you continue investing for 20 years.

What do you think would have happened? Who would have had a bigger corpus at the end of the 20^th year? And what about earlier years?

Here is what happens:

-At the end of 5^th year - Rs 8.5 lakh (You) and Rs 15.0 lakh (Friend)

-At the end of 10^th year - Rs 28.7 lakh (You) and Rs 45.8 lakh (Friend)

-At the end of 15^th year - Rs 72.6 lakh (You) and Rs 1.04 Cr (Friend)

-At the end of 16^th year - Rs 85.9 lakh (You) and Rs 1.21 Cr (Friend)

-At the end of 17^th year - Rs 1.01 Cr (You) and Rs 1.40 Cr (Friend)

-At the end of 18^th year - Rs 1.19 Cr (You) and Rs 1.62 Cr (Friend)

-At the end of 19^th year - Rs 1.40 Cr (You) and Rs 1.86 Cr (Friend)

-At the end of 20^th year - Rs 1.63 Cr (You) and Rs 2.13 Cr (Friend)

Investing more

Your friend has a bigger corpus than yours! That too when you were earning higher investment returns of 12 per cent than his much lower 8 per cent.

So, in the above example, one who earns a much lower 8 per cent return on investments does better. But more importantly, he had a higher savings rate. So he was saving more. And that compensated for the lower investment returns.

Most people just keep looking for high-return investment bets here and there. But when your portfolio is in the accumulation phase, and more specifically during the initial years, your savings rate will play a much bigger role in how much corpus you have rather than the return on your investments.

Another fact is that your savings rate is something that you control. But the investment return you get is something that you can’t really control. It depends on the gods of the financial markets.

In the later years, your investment returns become more important. Much more important than your contributions (or savings rate). Why?

Because, by then, your portfolio size will be huge in comparison to your contributions. Therefore, you will not only need to ensure that you generate good returns, but also focus on protecting your (large) portfolio from big losses.

The real impact of investment returns is felt only when your portfolio has crossed a reasonable size. Till then, focus on pushing your saving rate higher.

So remember, your savings rate is more important initially. But later, it’s your investment return that becomes very important.