Worry about saving first. Then your investment performance.
Investment returns are important. No doubt. Just a few extra percentage points compounded over time can add tens of thousands to your portfolio or retirement nest egg. But sometimes we get too caught up in the numbers and chasing investment performance when we lose sight of what’s arguably more important – how much we’re saving. And other times we just lose sight of what we’re really getting.
The 100% return
I was having a conversation with a friend who was complaining last year when he got his annual investment performance report from his company that his investments in his company’s defined contribution retirement plan weren’t doing all that great. Now, most defined contribution plans that companies offer here in Canada seem to be restricted as to the funds they offer. My last company plan was like that. You had to pick from a pool of a little over 20 funds – of which maybe 5 were balanced funds, 5 Canadian equity funds, 5 U.S. equity funds, 5 global, 5 fixed income and so on. On the one hand, it’s a good idea for the average investor, in that they don’t offer terribly risky funds – this is your retirement nest egg after all – but you also get handed a limited (crappy) selection of funds that you would probably never pick yourself. So, in the end, the returns never end up being that great, or are they?
So he was complaining about a 4% return. Not a great return. But not a terrible one either. So I joked “well, at least you’re not losing”. But I wasn’t really joking and he didn’t really seem all that amused. So I told him, “you’re not making 4%, you’re making 104%, and that’s a pretty good return to me.” He laughed, “what do you mean 104?” Most people forget that in defined contribution plans / 401k’s, where the company matches up to a certain percentage of what you contribute, they are doubling your investment right off the top. Where else can you get a return like that? I can be happy with that.
We’ve gone through a few years now of great returns. Markets across the world are at all-time highs now and continue to rise, ignoring all sensible market indicators. Low-interest rates have definitely fuelled a lot of it. Where else is someone to park their money? But what happens when interest rates rise? Or are we headed for a big correction before then? No one can say for sure, and it’ll differ depending on where you live too.
If we look at the US S&P 500, since 1960, there have only been 3 years when the market did NOT experience a 5% correction. So for my defined contribution plan, I’ve been slowly moving to more conservative investments, for now, preserving some of my capital. After all, I’m already getting a 100% match dollar for dollar, up to 3% of my earnings. Sure, it would be nice to get a few extra percentage points above that. But as long as I’m not losing, I’ve already doubled my money. I’m not all that worried about a percentage here or a percentage there.
Why what you save is more important
Is what you save more important than your return? Absolutely! Let me paint this simple example. Let’s say you set aside $100/month, Warren Buffet lent you his good luck shoes and you make a great 10% return, compounded monthly. At the end of the year, you made $1,256.56. Let’s say you decide to double your savings and put aside $200/month, but instead are wary of the market and decide to lock it into a safe 1-year Guaranteed Investment Certificate (GIC) bearing a paltry 2% return (compounded annually). Can you guess who comes out ahead? Right, of course, the paltry 2% GIC. At the end of the year, you’ll have accumulated $2,421.92, and all with no risk. Extrapolate both numbers 10 years, that works out to $20,484.50 and $26,519.36, respectively. A 2% return trumps the 10% return.
Now of course this may sound overly simplistic and you’re probably thinking, okay, but you’re asking me to double my savings. But you don’t have to double your savings. All I’m really saying is if you focus all your energies on how well your investments are performing, and don’t pay attention to what your saving, you’re really not coming out any further ahead.
Of course, there is the flip-side argument that if you can generate a larger return, you don’t have to save as much. And this is true. But what kind of returns are you chasing? In most cases, buying index funds, have been shown to outperform the majority of management-led funds and investment earnings are not guaranteed after all. Savings can be.
I’m not disputing the fact that investment returns are important nor that you shouldn’t try and get the best return on your investments. But I’m always cautious when the markets reach these peaks. And if you want to really bump up your investment returns, just start saving more. Save early, save often.