“Every little bit counts!”
This approach is often taken by those of us that try hard to save our money. This popularly applies to saving money by methods such as:
- Cutting coupons
- Price comparison shopping
- Not spending money
In other words, focusing on the expense side of the equation.
The other side, as I allude to here on occasion, is growing your income. Whether through one’s career or entrepreneurial ventures, increasing the top line is very important. After all, you can only save so much. Maximizing income while minimizing expenses is a good thing, as it results in savings.
Great! Mission accomplished, right?
Well, it’s a really good start. But what you do with your savings matters too. In other words, that savings has to be managed properly.
- Don’t lose money. Check out Warren Buffet’s Rule #1 as a primer to this concept. Mathematically, it’s more important than might meet the eye.
- Have your money work for you. Your money is like an teammate of yours, in a way; you can go far on your own by saving, but letting your money do some work to can take you even further.
With this second principle, I’m talking about the percentage return that you earn on your investments. A big driver of this is asset allocation, which is a broader topic unto itself. However, when you look at rates of return, it’s really interesting just how important each percentage point is. Once again:
“Every little bit counts!”
I decided to go egghead today, and run some numbers to illustrate why rate of return is important. Now, I realized this before, but revisiting it reminds me of how important it is to grow/protect your rate of return.
Let’s assume that you take a lump sum of $10,000, and hold it for 20 years. The result: you’ll have $10,000 after 20 years. Now, of course, I’m not counting carrying costs or the time value of money. Just trying to keep it simple for illustrative purposes. Bottom line: if you earn nothing, you’ll have no growth.
Now, let’s look at how much you would have in 20 years if you invested $10,000 at different rates of return, compounded annually:
|Rate of Return||Total After 20 Years|
Clearly, there is a big difference between earning a paltry 1% and a robust 10% annually. When this is extrapolated to higher initial investment levels, it’s clear how the rate of return one earns can be a game changer.
There are many ways to apply this. Two examples that come to mind are:
- Properly Allocating Assets Among Classes.If assets are held in low-yield, minimal growth vehicles, the downside might be limited in some cases. However, the risk aversion can be costly in terms of growth potential. It’s important to look at historical and expected rates of return on different asset classes, so as not to shortchange oneself from an overall portfolio perspective.
- Smart Choices Within Asset Classes. Let’s say you’re paying a management fee on a mutual fund, instead of using an index fund. Or, let’s say you’re earning a lower rate of interest on a CD than you could at another institution. Even a 1% difference can add up over time. The difference between 3% compounded annually vs. 2% compounded annually is $3,202, in the above example. All attainable through smart, informed choices up front.
Every percentage point counts, and can make a big difference over the long run when compounded annually.
Many of us realize this concept, but get caught up in the income and expense side – the latter being an obsession for many – and lose sight of how important this is for managing the money that we do actually save.
What about you?
How much time an effort do you spend on managing your savings to optimize your rate of return – as opposed to spending time figuring out ways to get the savings in the first place?