How Time and Annual Returns Affect Saving Rates

Time and Annual Returns

I recently watched an interesting YouTube video about time and the rate of return, by finance columnist Preet Banerjee. He explains the relationship between an investor’s time horizon and his or her rate of return. Here’s a question to illustrate an example. If our goal is to accumulate $100,000 by age 65, how much do we need to save per month?

Here’s a table that breaks down how much investors will need to put away each month depending on their current age and the expected rate of return. For example, we can see that someone at age 30 who expects their portfolio to return 4% a year should save $109 per month.

As we can see, the rate of return is a much stronger factor for investors with a longer time horizon. The 20 year old still has 45 years until retirement and how much he has to save is heavily influenced by his average investment returns. On the other hand, the 60 year old investor only has 5 more years before retirement so most of his accumulated wealth will come from savings rather than from investment gains. This means he shouldn’t take on more investment risk and reach for higher returns since the his rate of return simply doesn’t matter very much. This is why I have a relatively high risk tolerance, even though some people don’t approve. It’s because I’m in my twenties and if I can get that higher rate of return on my portfolio now, my life would be so much better in the future. 😀

The other thing to note about the table is that time trumps rate of return in most cases. If one person starts to invest at age 40 and earns a 2% rate of return, and someone else starts just 10 years later but earns a 6% rate of return, then the first person would still come out ahead despite making 4% a year less. In other words if we start investing 10 years earlier than our peers, then that will have the same effect as outperforming their investments by more than 4% each year. Wow! Let that sink in.

We can also track our retirement progress with this information. For example if we plan to retire in 15 years we can use the AGE 50 row of numbers in the table above. Let’s say we want to accumulate an extra $300,000 between now and our retirement date. We know the table is based on an accumulation of $100,000. So to find out how much we need to save each month we just multiply the green numbers by 3, since $300,000 is 3 times $100,000. The tricky part is guessing which rate of return we are most likely going to see over the next 15 years, but I think 4% sounds like a reasonable assumption.

So start investing as early as possible and front load more risk to the earlier stages of wealth accumulation. 🙂

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