An article on the Vanguard Advisors Blog discussed the trade-offs involved in adjusting an investor’s savings rate and the risk level of their portfolio – Investor success: Measured in dollars, not (per)cents.
A portfolio’s value can grow through both capital contributions and return on capital, but only capital contributions can grow wealth reliably. Saving is our contribution to our own investment success and, importantly, unlike the investment returns we seek, its benefits are both more certain and within our control.
The chart below shows projected outcomes based on savings rate (4% or 6%) and portfolio risk level (conservative, moderate, or aggressive). You can see visually that the combination of 6% savings rate and moderate risk (50% stocks/50% bonds) has both a higher average outcome and fewer poor outcomes than the combination of 4% savings rate and aggressive risk (80% stocks/20% bonds)
Part of this should be expected – you’re saving 50% more in dollars when going from a 4% to 6% savings rate. But on an absolute level, perhaps that amount of dollars is something you can swing.
Vanguard did a similar study called Penny saved, Penny earned back in 2011 that compared three levers: savings rate, portfolio asset allocation, and also starting to save earlier. Take the following baseline scenario:
- Investor begins working at 25, but starts saving at age 35.
- 12% savings rate
- Moderate asset allocation (50% stocks and 50% bonds)
- Salary starts at $30,000 but increases with age
Now, here are three ways in which a worker could increase their final savings balance at retirement (age 65).
- Option #1. Invest more aggressively with an asset allocation of 80% stocks and 20% bonds, while keeping your 12% savings rate and starting age of 35.
- Option #2. Raise your savings rate to 15%, while keeping your starting age of 35 and 50/50 asset allocation.
- Option #3. Start saving at age 25 instead of 35. while keeping your 12% savings rate and and 50/50 asset allocation.
Which single option do you think has the most impact? The results are based the median balance found after running Monte Carlo computer simulations based on 10,000 possible future scenarios for each option.
|Scenario||Median Balance at age 65||% Increase vs. Baseline|
(Aggressive asset allocation)
(Raise savings rate)
(Start saving earlier)
Between the three “levers” you could pull, starting to save earlier wins by a significant margin, which is an important truth but minus a time machine today is the earliest we can start saving more. After that, a higher savings rate is a more reliable path to improving your odds for success. Investing with significantly more risk performs somewhat similarly on a median basis, but actual results will vary the most widely.
I suppose my version of this is that an investor should keep working hard to maximize their savings rate, but only work hard to find a “good” asset allocation once and then let it be. My definition of “good” asset allocation is one that considers your financial needs, your knowledge, and as a result is something that you can keep forever. Don’t look for the “perfect” asset allocation, as these can only be known after the fact and are constantly changing. Too often, they are based on data mining and recent performance. Look at any asset allocation with growing popularity, and the asset classes that make it hot have probably done well in the past decade. You can quote “long-term” numbers from long periods like 1970 to 2015, but these numbers are still strongly influenced by recent past performance.