When thinking about investing or saving towards retirement, many are focusing on their rate of return. Especially when things are going well, it’s enjoyable to talk about your investment returns. I get that. You can talk about your investment returns, just don’t forget the savings rate.
During your early years of saving for financial independence, the savings rate is your most important number. Sure, having a high rate of return is fun, but it shouldn’t be your priority. After you have some leverage in the form of thousands of dollars, your rate of return comes in.
There is a lot of people focus on the rate of return. As does my friend, Dave.
The Story Of Dave
Dave keeps talking and talking about his cryptocurrencies. He checks his portfolio every day, where he shares what his year to date return is. Dave bought a lot of crypto’s when the market was low throughout the year, for around $1000. Now his portfolio has a value of $1500 within a year. That’s a 50% increase in only one year time. Talk about beating the market!
I know how Dave is wired. We talk about how we’re going to retire early and save most of our income. He’s very interested in personal finance. His habits are different than mine though. He is planning out to buy new shoes, clothes, an Xbox, a Macbook, every time he gets his salary. He’s setting aside $80 per month for his cryptocurrency investments, which after a year grew to $1500.
50% Return On Nothing – Still Nothing
In his mind, he’s killing it and his cryptocurrencies will for sure enable him to retire before 45. Of course, a 50% return on investment in one year time is amazing. He’s outperforming the market and doing a great job. He turned his $1000 investment in $1500 in a year time. If my investments would do that, my time to retirement would be a lot shorter.
The point is, he’s thinking that this monthly $80 in cryptocurrencies will be able to retire him at 35. While I love his determination, I also think there should be a realistic plan on the table how you’re going to accomplish retirement. If he’s putting money aside for a year, and he has saved $1500 until now – it’s not really moving the needle. I didn’t ask if he had any specific retirement number, but $1500 isn’t gonna be enough for anyone.
We want dollars. Thousands and thousands of them. Preferably even more.
How are we doing to do that? We’re going to save a big percentage of our income, in order to get a lot of money in our savings and investment account. Dollar dollar bills y’all!
Big Returns Are Sexy
New investors often look at big returns. Big returns are sexy and they give you the feeling that you’ve received ‘free money’. While big returns are every investors’ dream, it’s not something that you should focus on at the beginning of your journey.
If you’re a new investor and you have $1000 invested, will the rate of return make a big impact? For a 50% return on investment, you ‘only’ gain $500. What if he would have saved 50% of his income and he would have $10,000 in the bank. His investments would need a 5% increase to have the same absolute gain.
While big returns are sexy, it’s important to first build up your investment portfolio. Once you’ve built up your investment portfolio, your rate of return will actually start having some impact.
Compounding Without Anything To Compound
“Compounding interest is the eighth wonder of the world. He who understands it, earns it. He who doesn’t, pays it” – Albert Einstein.
Compounding interest is awesome. It means that your returns are also generating returns. When you’re for example having $10 that doubles every day for two weeks, you get the following results:
Day 1 $10
Day 2 $20
Day 3 $40
Day 4 $80
Day 5 $160
Day 6 $320
Day 7 $640
Day 8 $1,280
Day 9 $2,560
Day 10 $5,120
Day 11 $10,240
Day 12 $20,480
Day 13 $40,960
Day 14 $81,920
Let’s Make It Visual
When we put this into a graph, you get the following visual representation:
This example illustrates compound interest and its returns. When you double the $10 for only two weeks, you already have $81,920.
While compounding interest is great, it might put the focus on the wrong things early in the game. When your investment amount is not so big yet, it’s more important that you increase the principal amount. If you look at the example, early in the days the compounding doesn’t have as much effect. $20 becomes $40, that’s it.
You can see that most of the growth happens in the last few days when there is already a significant amount saved. That means instead of focusing on the rate of return, we should only focus on our savings rate at the beginning of the game. The savings rate is the only number you can influence – put as much money away so that you can get to those big number earlier.
The only way that you can get to compounding significant numbers over time, is by saving as much as you can to get to the bigger numbers as soon as possible. That’s basically how I’m approaching financial independence, by focusing on my savings rate.
How To Get To Those Numbers?
I can imagine that you’re now thinking like: okay, so I need to save as much as I can. HELP!!
First, let’s talk about how to calculate your savings rate. I calculate it as: Amount Saved divided by Net Income. If you want to read more in detail about that, you can go here to read about the savings rate.
Now, let’s look at steps you can take to increase your savings rate. It’s important that you set up a budget that is fitting you. A budget has this bad name of being restrictive, which I don’t agree with. A budget is a way to prioritize the things that are important to you. Saving money can be fun and exciting! Anyways, if you’re not the budget type, you can simply pay yourself first.
I’ve also listed how I save over 50% of my income, and you can too!
Besides saving more money, you can also make more money. A lot of people underestimate the importance of your career in the whole picture. If you’re getting consistent raises over a specific period of time, the compounding effect will also kick in. Not sure how to get a raise? Read more about it here. I got a 20% raise after one year of working, so I’m giving you my tips and tricks in order to get the same thing done yourself!
Besides all of this, I’ve received some great money lessons from my dad when I was young. You can read more about them here.
Focus On Things You Can Control
Last week I’ve read Seven Habits of Highly Effective People, which is truly a great book and I would recommend it to all of you. They speak about this circle of control and circle of influence.
Seven habits of highly effective people says that you should only focus on the circle of your control. When you are going to focus on the circle of concern, you’re wasting your energy on this you can’t change. Because you’re wasting your energy on the circle of concern, the circle of control will get smaller – as less energy is directed there.
What I’m trying to say is: focus on things you can control.
Your savings rate is something you can control, your rate of return is something that is out of your hands. Of course, you can invest in Peer-to-Peer lending to get a fixed rate of return, but also that is beyond your influence. As soon as you have put your money on the platform, it’s not in your control anymore.
Sure, it’s fun to have a rate of return of 50% yearly and make $500 on that. Will it change your path to retirement? Probably not. You need a significant amount of money first. Your rate of return will get more important once you have a lot of money saved. 10% return on $300,000 is $30,000 per year, that will have a big influence. Those $500, it’s nice, but it doesn’t move mountains. That’s why your savings rate is more important than your rate of return, particularly at the beginning of your journey.
Do you focus on your savings rate or your rate of return?