Some years ago three of my friends made a bet: They each started with $5,000, and the first to the $1 million mark will win $500 each from the losers. (Even though they're allowed to contribute as much as they want to their respective pots, yep: It's a really long-term bet. Hopefully I'll be around to see how it turns out.)
Which means they obsess over the rate of return on their investments.
Each embraces a different strategy. One might as well be a day trader; he constantly churns his portfolio. Another sees himself as the next Warren Buffett, spending time each day reading financial reports, analyst guidance, etc. Another is deep into FOREX trading, sometimes talking about currencies I didn't even know existed. (Ever heard of a Ringgit?)
All of which makes sense, in concept if possibly not in approach. If your goal is to achieve a net worth of $1 million in liquid assets, the greater your rate of return, the faster your savings will grow.
That's why so many people spend considerable time and energy focusing on their return on investment, hoping for 5 percent. 8 percent. Or maybe even a 10 percent annualized return, the holy grail of investing -- which, over a period of years, is really hard to do.
But here's the thing. If you want to build wealth, especially early on:
Your rate of investment return is important... but your rate of savings is everything.
Say you make $50,000 a year and save 2 percent of your salary. That means you save $1,000 the first year. If you earn a 5 percent return on that money, after one year you have $1,050. Not bad. If you manage a 10 percent investment return, you have $1,100. Much better. Twice as much better.
But if you increase your rate of savings by 1 percent, to 3 percent, you have $1,500 -- even if you don't generate any return at all.
And that's why:
To build wealth, the most important thing you can do is to focus nearly all your attention on your rate of savings, not your rate of return.
I know what you're thinking: If your budget is tight, finding an extra 1 percent in savings might be really hard.
But, unlike investment returns, you have significantly greater control over your rate of savings. No one can predict the future, especially where financial markets are concerned.
But you can decide to eat out a little less. Or cut the cable cord. Or switch to a cheaper cell plan. Or shop for cheaper insurance. We recently bundled our auto, homeowner's, and rental property insurance under one provider and saved a total of over $2,000 per year. (Should have done that a long time ago.)
You can't control how much you earn from your investments.
But you can control how much you spend.
And, although possibly to a lesser extent, you can also control much you earn.
Say you make $50,000 a year and save 3 percent of your salary, or $1,500.
Then you start a side hustle that generates $200 per month after expenses and taxes. If you decide to invest all of the proceeds, you save an additional $2,400 per year. Now you make $52,400 per year (I know I just combined gross and net incomes; I'm keeping the math simple) and save $3,900 per year -- which is a 7.8 percent rate of savings.
Invest that money for 10 years... and even at a 1 percent return you'll have $45,110.
Compare that to saving $1,500 per year... and even at a 10 percent rate of return, you'll only have $27,796.
Yep: Rate of savings matters a lot more than rate of investment return. (In case you're wondering, in the scenario above you would need to average 19 percent in annual investment returns in order to match the results from a higher savings rate.)
Which means your time -- and my friends' time -- is much better spent finding ways to save more money, or make more money, than it is trying to squeak out a slightly better rate of investment return.
Granted, at some point your rate of investment return will matter more than your savings rate.
And it's also true that the lower your annual investment returns, the longer it takes for investment returns to become more important to net worth growth than savings.
For example, if you invest the same amount of money every year and manage a 5 percent annual return, it takes approximately 15 years for earnings from investments to outpace the amount you invest each year. Average 8 percent, and it only takes 10 years for you to cross the savings rate/investment rate threshold. The larger your egg, the greater the net effect of your rate of investment return.
If you start with $1,000 and earn 10 percent, you have $1,100. But if you start with $100,000 and earn 10 percent, you have $110,000.
That's why, as many investors like to say, the first $100,00 is the hardest. Early on, your rate of return -- even a stellar rate of return -- has relatively little impact on your overall net worth. Earning 8 percent on $15,000 is an awesome result... but still only results in a portfolio worth $16,200. It's a great result in terms of percentage gain, but not a huge result in terms of raw dollars.
Earn 8 percent on $500,000, though, and you have $540,000 -- a huge result in terms of raw dollars.
So For the Next 10 Years...
Focus on increasing your savings rate of return. That's the fastest way to grow your net worth.
Spend a little of your time learning about investing. (Or do what Warren Buffett suggests, and invest your money in an index fund.)
And then spend most of your time finding ways to save more money.
The faster you build your savings -- the faster you achieve a critical mass of wealth -- the greater the effect even marginal gains in investment return will have on your principal.
Which may require making more money. Which may mean starting your own business -- since, after all, that's the only way to get really, really rich.
For the first ten to fifteen years, how much you save per year makes a much greater difference to your current net worth -- and to your eventual net worth -- than how much you earn each year on those savings.
That's true whether you're trying to win a $500 bet... or much more importantly, to achieve whatever the words "financial freedom" mean to you.