The concept of “investing success,” as it often appears in the media, is a tangled web to me. Every time I read something about the topic, I can’t help but feel that the authors are confusing two very different efforts: investment success and investor success.
Yes, this is nuanced, but yes, it matters. Too often, investment success is defined in either absolute or relative returns (which is another nuance for another time). While I understand why a portfolio manager would focus on higher returns, I’d argue that this shouldn’t be the benchmark for success for the typical investor. Instead, they should be focused on building the wealth they need to fulfill the objectives that matter most to them. Wealth is measured in dollars, not percents.
Your Savings Rate Is a Huge Factor in Your Success as an Investor
Sure, better returns build more wealth faster, but higher returns are not essential to building wealth. Investing is a partnership between an investor and the markets, where an investor provides the capital and the markets provide the prospects for a return on that capital. Understanding this relationship introduces a most important point for building wealth — capital contributions.
Sign up for Kiplinger’s Free E-Newsletters
Profit and prosper with the best of expert advice on investing, taxes, retirement, personal finance and more - straight to your e-mail.
Profit and prosper with the best of expert advice - straight to your e-mail.
A portfolio’s value can grow through both capital contributions and the return on capital, but only one part of this equation can grow wealth reliably: our capital contributions, or more generally, our savings. It’s our contribution to our own investment success and importantly, unlike the investment returns we seek, its benefits are both more certain and within our control.
Contributing More to Savings vs. Taking More Risk
As illustrated in the figure below, moving from a more conservative asset allocation (50% stocks/50% bonds) to a more aggressive one (80% stocks/20% bonds) tends to widen the range of expected outcomes. At any asset allocation choice, higher savings levels contribute to higher best, worst, and median expected outcomes, due to the higher levels of capital contributions.
What is often overlooked, however, is that higher levels of capital contributions allow investors to improve their expected outcomes not only relative to the same asset allocation, but also relative to a higher risk allocation. For example, for the 50% stocks/50% bonds portfolio, a 6% contribution rate provides a better range of total potential outcomes than a 4% savings rate for the same asset allocation and for the majority of expected outcomes in even riskier allocations.
Higher returns are welcomed, but they are a less reliable source of asset growth and wealth creation.
A most extreme version of this scenario played itself out on the national stage when the Powerball lottery offered a $1 billion-plus jackpot. While the lottery gave a player a chance for a fabulous return on their $2 ticket, probability-wise, a player’s wealth would increase more certainly if they didn’t play the lottery at all (since they’re most likely to lose their whole “investment” in lottery tickets).
The Bottom Line for Investors
Investing involves tradeoffs, and an important part of the financial planning process is for an investor to define their willingness to forgo spending now to improve their prospects for building wealth that can provide for their future needs. This is critically important, as a higher savings rate provides a higher probability of investor success. This is due to the partial shift in responsibility for building wealth from the less certain returns from risky assets to a more certain stream of capital contributions.
In the end, if an investor is trying to maximize future wealth, we believe a marginally higher savings rate, rather than a substantially higher risk portfolio, will be more likely to lead to investor success.
-
Strategies to Optimize Your Social Security BenefitsTo maximize what you can collect, it’s crucial to know when you can file, how delaying filing affects your checks and the income limit if you’re still working.
-
Don’t Forget to Update Beneficiaries After a Gray DivorceSome states automatically revoke a former spouse as a beneficiary on some accounts. Waivers can be used, too. Best not to leave it up to your state, though.
-
What’s the Difference Between a CPA and a Tax Planner?CPAs do the important number crunching for tax preparation and filing, but tax planners look at the big picture and come up with tax-saving strategies.
-
Charitable Remainder Trust: The Stretch IRA AlternativeThe SECURE Act killed the stretch IRA, but a properly constructed charitable remainder trust can deliver similar benefits, with some caveats.
-
Three Ways to Take Control of Your Money During Financial Literacy MonthBudgeting, building an emergency fund and taking advantage of a multitude of workplace benefits can get you on track and keep you there.
-
How Did O.J. Simpson Avoid Paying the Brown and Goldman Families?And now that he’s died, will the families of Nicole Brown Simpson and Ron Goldman be able to collect on the 1997 civil judgment?
-
What Not to Do if an Employee or Loved One Is KidnappedBusinesses need to have a crisis plan in place so that everyone knows what to do and how to do it. Sometimes, calling the authorities isn’t recommended.
-
Why You Shouldn’t Let High Interest Rates Seduce YouWhile increased interest rates are improving the returns on high-yield savings accounts, that may not be an effective place to park your money for the long term.
