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Advice for Young Saver
(Updated 9/9/07)
“To a young adult, consistent savings is more important than the rate of return on those savings.” So advises Rick Ferri in his book Protecting Your Wealth in Good Times and Bad (now out of print). To show why this is so, I have recreated the example that Ferri uses in his book. Let’s say that two young people both start working at age 22. They both start with an annual salary of $20,000 and receive 3% pay raises each year. At this point, their identical situations diverge. One saves 5% each year from her salary and earns 10% on those savings. The other saves 10% each year from her salary but only earns 5% on those savings. How much have they accumulated by the time they reach age 40? (Assume no tax consequences.)
By the time they reach age 40, we see from the chart above that the person who saved 10% each year (and earned 5%) accumulated $15,000 or 24% more than the person who saved 5% each year (and earned 10%). The lesson is that, for the young person, the savings rate is more important than the rate earned on those savings. However, as the years continue to go by, the effect of compounding at a higher rate will overtake the amount that was compounding at a smaller rate.
Keep in mind that these numbers were for illustration purposes only. While earning a 5% return is very doable, earning a 10% return will require devoting much of one’s savings to riskier (and more volatile) investments. See note 1 below. However, as investors get older and approach retirement age, their appetite for risk generally diminishes. So at some point in mid-life, it may be wise to add fixed income investments (bonds and money market) to help smooth out the ride. The trade-off of lower volatility from a more balanced portfolio will be a lower rate of return on those investments. See note 2 and note 3 below. |
| Note 1 |
These two charts track a portfolio composed of 100% S&P 500.
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Annual Returns (1926-2006, Nominal Values)
$1000 Annual Portfolio Contributions (1968-2006, Nominal Values) 
This chart was created by my Dollar-Cost-Average Growth (xls) |
| Note 2 |
These two charts track a portfolio composed of 60% S&P 500 and 40% 5-Year Government Bonds. ~~~
Annual Returns (1926-2006, Nominal Values)
$1000 Annual Portfolio Contributions (1968-2006, Nominal Values) 
This chart was created by my Dollar-Cost-Average Growth (xls) |
| Note 3 |
These two charts track a portfolio that starts out with 100% S&P 500 at age 22 in the year 1968. 5-Year Government Bonds are added each year using the formula “Age in Bonds minus 22”. At the end of the 39-year period, the investor is 60 years old. In the final year, the portfolio is composed of 62% S&P 500 and 38% 5-Year Government Bonds.
Annual Returns (1968-2006, Nominal Values)
$1000 Annual Portfolio Contributions (1968-2006, Nominal Values) 
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