The Importance of Rate of Return

“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:

  1. Cutting coupons
  2. Price comparison shopping
  3. 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.

  1. 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.
  2. 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.

For example:

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
1% $12,202
2% $14,859
3% $18,061
4% $21,911
5% $26,533
6% $32,071
7% $38,697
8% $46,610
9% $56,044
10% $67,275

 

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:

  1. 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.
  2. 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?

Comments

  1. says

    God do I love charts and graphs!
    For the first time I have an emergency fund and am building my savings! My next step is to figure out where to put it all. The emergency fund needs to go somewhere accessible enough that I can pull it out when needed and not get dinged with fees.
    When I started paying down my debt aggressively I had a high paying job. I have to admit it was very exciting to make huge payments on my credit card. The down side was the job took a lot of my time and was very stressful. I decided that the payoff of that job was not worth it!

    • Squirrelers says

      Molly – that’s great that you now have an emergency fund and are building savings! Those are vital things to have, no question. I’m a proponent of 9 months of expenses (Preferrably a year) in the emergency fund, and a solid percentage of income into savings.

  2. says

    If only the stinking savings rate would increase, even back up to a measly 3%, I’d be happy having my money sit in my savings account! It’s so frustrating knowing that when I was a kid, and had no real money to speak of, the interest rate was around 8%. ARGH! Thanks for sharing your chart, it reminded me to keep looking for better investment vehicles.

    • Squirrelers says

      @LittleHouse -

      Yes, I know what you mean about the savings rates being so low! Of course, to my understanding prices in general haven’t really been increasing either, so perhaps it’s a wash. There was even talk of deflation for a while.

      As for the data, I pulled it together to remind myself about how every percentage point counts. We all intuitively know that, and I’ve done this type of analysis before many times, but it’s good to remind ourselves sometimes.

      Thanks for stopping by!

  3. says

    Your next post should be where to put the money to get a high rate of return. For many of us, there aren’t that many options. In the past, I just put it all in stocks and now realize that was a mistake as I took a big hit during the downturn. I failed at rule #1 badly.

    I’m thinking more and more that the answer is a side business where you have a little more control of the potential return. I suppose it’s also true about a corporate career as well. Investing in skills can also pay back big returns in terms of annual salary.

    • Squirrelers says

      @First Gen American –

      Many of us – if not most – got hit hard by the stock downturn, so we share your pain! With the good comes the bad, and the bad is that volatility that’s a part of it. I’m a fan of stocks over the long term…just a bit concerned about other things, such as our national debt, and how this impacts our financial futures.

      Good point on investing in other ways, such as skills or a side business. Diversification is a good thing.

  4. says

    I probably don’t spend as much time as I should…thanks for the reminder! My money market account was at 4.something % when I started it five years ago. Now it’s at 1.something % and I haven’t really touched it because that requires effort.

  5. says

    Well, I used to analyze my investments more, but that got me nowhere. I know that the 10,000 I invested when I started working is nowhere near the 67,000 it would be worth if it made 10 percent a year. It isn’t even near the 5 percent number. However, I know if I shifted more to bonds, we would have one of those banner stock market years that if you removed it from your equations, you would go from earning 8 percent to 2 percent…

    I really don’t know what to do at this point because it seems like I have failed to a degree over my investing career. Thank God I have equity in my house at least or I would really be bummed!

    • Squirrelers says

      @everydaytips – I think that many people in our generation have faced some real ups and downs, with the .com situation, housing, recent economic woes. Sometimes I think that just making it through unscathed in a big way is an accomplishment in itself. I’m thankful for whatever I have, that’s for sure!

  6. says

    I have most of my money in stock as well and failed rule #1 during the downturn. The portfolio came back and is better than ever now though.
    Of course, I would love to get 10% return on my investment. Teach me wise one.
    Now, I’m thinking rental income is the way to go.

    • Squirrelers says

      @retirebyforthy – If I was wise enough to predict where the 10% returns are, it would be a great thing:) Funny, it wasn’t too long ago that 10% returns were considered passe….almost boring to some degree. Yesterday’s trash is today’s treasure. One thing to keep in mind is the historical performance of stocks…over the long run. This period of volatility seemed to scar many people.

  7. says

    Nice post. Indeed, a small % adds up to a big amount over time, and this also applies to debt as well, as well as the MERs. MER of 1.50% versus 0.50% doesn’t sound like a big difference? Well, it is over the long haul. I like that you mentioned that. :)

    • Squirrelers says

      @investitwisely – thanks! The small percentage can add up, no question about it. When those small percentages are applied to sizeable dollar amounts, and compounded over many years, the actual dollar difference can be significant!

  8. says

    Squirrelers, most of my income-paying investments are in dividend paying stocks in the active part of our 401K, and passive money market funds and Tips in the other half. The time spent is mostly up front, before making the buy. The yields vary from 4 to 12 percent, depending on the stock price, so I don’t spend a lot of time averaging it out. I get a quarterly statement, and that’s about it. But your point is well made, compounding interest or gains do add up over time.

    • Squirrelers says

      Andrew – thanks for sharing. Interesting that you’re using TIPS to a high degree like that. I did a post on TIPS within the last month or two, but haven’t yet taken the plunge. They have some real attractive features.

  9. says

    I spend 90% of my time figuring out how to save and earn and my husband is in charge of all of our investments besides the 401(k) and our first Roth IRA (both of those are put directly into target date mutual funds we chose a while ago). :-)

    • Squirrelers says

      Crystal – hey, teamwork can be a great thing, right? Based on what I read on BFS, I’m guessing you’re resourceful at improving earnings and savings and do a great job with it. Congrats on the Roth IRA.

  10. says

    I use to spend many hours playing with interest rates in a spreadsheet that tracked my: 401k, Roth Ira, Kids investments, 529s and my brokerage account.

    I semi have my 401K on autopilot, only occasionally rebalancing. The 529 I have no control over since it’s mutual funds :( So mainly I play around with my brokerage and Roth… The market downturn has through my rates off though :(

    After the horrible last few years, I’d be happy with a 7 or 8 % return across my accounts… :(

    • Squirrelers says

      @moneyreasons – your comments on being happy with 7 or 8% really speaks to how things have changed over the years. Not long ago some people were trumpeting 20% annual returns. By the way, I know what you mean about A) playing around in spreadsheets regarding interest rates, and B) the reality that 529 accounts offer less control!

  11. says

    Great article. When it comes to investing, every percent really counts and it does make a big difference especially for retirement. Even a 1% increase on the rate of return could mean thousands of dollars when invested for 20 to 30 years.

    • Squirrelers says

      Ken – it’s really something how even a small percentage can make a big difference though long-term compounding. Another reason why math skills are good for everyone – just being aware of this can cause people to align their investing and even savings behavior to make this happen. Also, thanks – I’m glad you liked the article.

  12. says

    Excellent post. Case in point- my mom set up some GIC’s for us (laddering etc) with some money that was given to us by relatives and friends since we were young. Fast forward 20 odd years later, and the small amount has turned into $20K!

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