The most important thing to understand is that your savings rate is a factor you can control, while investment returns isn't under your control.
Most people prefer to focus on their investment returns and it's natural to do so. After all, who wouldn't want their investments to earn the highest possible returns.
However, the number one question on investors' mind is the choice of mutual fund and the means to achieve higher returns, when in fact their focus should be on something else, at least in the initial years of their investment journey.
And that "something else" is their savings rate.
A simple example can explain how the amount of money you are able to invest is far more important than what return that invested money earns.Suppose there are two investors earning Rs 50,000 a month, which translates to an annual income of Rs 6 lakh. Their income increases by 10 percent every year. But there are a few differences between the two:
- Investor A has a saving rate of 10 percent and gets 15 percent return on his investments.
- Investor B has a saving rate of 20 percent but gets 8 percent return on his investments.
To put it simply, Investor A saves just 10 percent of his income (lower savings rate) but focuses on getting a higher return (15 percent annually). On the other hand, Investor B saves 20 percent of his income but invests in conservative products giving comparatively lower returns (8 percent annually).
Assuming that both of them keep investing over 20 years.
Any guesses which one of the two would have a bigger corpus after the fifth, 10th and 15th year?
It is Investor B - one who earns a much lower 8 percent return on investments, but more importantly has a higher savings rate of 20 percent.The figures for each five-year interval are as follows:
- Fifth year - Rs 5.5 lakh (Investor A) and Rs 9.0 lakh (Investor B)
- 10th year - Rs 20.0 lakh (Investor A) and Rs 27.5 lakh (Investor B)
- 15th year - Rs 54.6 lakh (Investor A) and Rs 62.9 lakh (Investor B)
Remember that Investor A saves less but gets higher returns. Whereas Investor B saves more but gets lower returns.
And if you see the table below, you will realise that it's not before the 20th year that Investor A goes ahead of Investor B
This shows that during initial years, the savings rate plays a much bigger role in how much corpus you have rather than the return on your investments.
In the graph below, the investor earning lower returns (8 percent) stays ahead of the investor earning almost double returns (15 percent) for 19 years, just because the savings rate of the low-return investor is higher.
The other important thing to understand is that your savings rate is a factor that you can control while the investment returns isn't under your control.
The idea is not to downplay the importance of getting good returns, but in the initial years, the corpus you accumulate is more about how much you can save rather than how much you earn on your savings.
Here's another example.
Suppose your goal is to save up Rs 1 crore. For the sake of simplicity, let’s assume that you can only invest Rs 10,000 a month or Rs 1.2 lakh a year for as long as possible (let’s ignore the possibility of increasing monthly savings). Also, let’s assume that the investment earns 10 percent a year - which is a reasonable assumption for long-term returns from a balanced portfolio of equity and debt.
Under the above scenario, you will reach Rs 1 crore in the 23rd year.
The chart below shows how savings and the return it generates, together take you towards the target of Rs 1 crore using the assumption of Rs 1.2 lakh annual investment earning 10 percent annual return.
If you notice the time periods mentioned at the bottom of the chart, it shows how much time it takes for each incremental growth of Rs 10 lakh. First Rs 10 lakh takes about 6 years. The second one takes about 4 years, then 3 years, 2 years and this continues to go down.
The reason for this is simple. The first Rs 10 lakh doesn’t receive much help from investment returns early on. It takes less and less time to accumulate each additional Rs 10 lakh because investment returns begin to account for more growth as years pass by.
Now focus on the blue and green areas in the chart above.
Blue area shows what you save (your contributions) and the green area represents the returns generated. In the initial years, the savings contribute more to the total value than compared to investment returns.
The table below shows this numerically - how the contribution of savings starts from a very higher percentage initially but goes on decreasing as the contribution of investment returns to the overall value increases
Although investment returns are important, in the initial years savings rate is more important than your investment returns. The real impact of returns is felt only when the portfolio has crossed a reasonable size. Till then, it’s more about your savings rate.So if you still haven’t got a large portfolio or it is still early days of saving for you, then focus more on increasing your savings rate than worrying unnecessarily about getting higher returns. Your savings rate matters much more than you think.You can now invest in mutual funds with moneycontrol. Download moneycontrol transact app. A dedicated app to explore, research and buy mutual funds.