Saving More May Allow You To Take Less Stock Market Risk

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Vanguard has a new article titled The importance of saving more, which tries to address evidence that investors may believe that “choosing investments that offer the possibility for relatively higher returns—and accepting the accompanying greater degree of risk—is a more viable alternative than saving more.”

In addition, the last few months probably have many of us re-examining the amount of risk we are comfortable with in our portfolios. I know I have. So what can we do?

Taken from the article, the figure below shows hypothetical outcomes for different portfolios based upon the following scenario: A 35 year-old individual begins saving 4% (grey bars) of his gross annual salary ($50,000, adjusted annually for inflation) each year for 30 years. In the red bars, the same individuals instead saves 6% of his salary. I highlighted two of the more interesting situations with the green arrows:

Here you see that based on historical data, the combination of a 50% stock/50% bond allocation and a 6% contribution rate leads to a similar range of outcomes as a 100% stock allocation and a 4% contribution rate. In fact, the former has a slightly better median outcome with much smaller swings over the years.

For example, a 50/50 asset allocation this year would have been down only around about 20%, instead of the stomach-churning 40% drop of a 100% stock portfolio. Wouldn’t that have been nice?

Higher savings provides a higher probability of success by shifting some of the responsibility for accumulation from the less-certain return stream of risky assets to a more-certain savings stream. In the end, if an investor is trying to maximize future wealth, a marginally higher savings rate rather than a substantially higher risk portfolio is the most likely path to retirement success.

As opposed to many rules of thumb, not everyone at the same age has to have the same asset allocation. Savers may get to take less risk and sleep better at night. 🙂 Something to think about…

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  1. All these “studies” assume 7 or 8% annual returns for the stock market while at the same time ignoring the secular market cycles. While in reality the stock market has in the past been cyclic with approximately 20 year time periods. We are very probably in the middle of a 20 year secular bear market. The last one lasted from 1967 – 1982 and had annual total real returns of 0.2% per year over that period, which included the punishing inflation in the 1970’s. Of course then the secular bull from 1982- 2000 produced 15.7% annual real returns… If you can live with that kind of risk, stay in the market.

  2. Not sure your reasoning makes sense. If you have 6% saved, why not just invest in 100% stocks? The bounds (25%-75%?) and median all indicate more return from the all stock portfolio than the split portfolio.

  3. I have a higher contribution rate and a higher savings rate.
    At the same time I am spending less. Like you Jonathan, I’m trying to beef up my cash pile just so that the emergency fund is beyond that 6 mos level.

    If anything has changed for those of us with jobs and no mortgage issues, it is how much we are building in liquidity. You had a post in ’06 called “Rankings Of Where To Put Your Money” and in this you state that we should “First Create an emergency fund with at least 2 months”

    But this isn’t ‘first’ in your rankings, it is number three. You still identify 401k and paying down credit card debt ahead of that. It would be interesting to see if your rankings of where to put your money are now different. You now seem to want a 12 mos emergency fund, which is definitely at least 2 mos worth, yet at the same time, you make certain that you maintain your contribution rate to your 401k and your IRAs – how can you resist the screaming buys? Based on your postings, it does not appear that your priorities have changed.

  4. While this works very well theory, its very difficult for people to save more than they are used to. Most will consider high risk for less saving. Of course there will always be the conservative few.

  5. I guess i have a higher risk tolerence than most, so i dont agree with your analyisis.

    you analyzed the following 2 scenarios:
    option1 — 6% contribution rate 50/50 stocks to bonds
    option2 — 4% contribution rate 100% stocks

    if the distribution of those 2 options are close, in this case
    option low, median, high (or whatever the range means)
    1 99, 213, 377
    2 95, 192, 425

    you are contributing 2% more each year, which totals over $30k. For your 30k, what have you gained? your “low” goes up 4k, your median goes up 21k , but you’ve capped your upside. The upside is actually down by 48k. You havent gained the extra money you put in long term.

    Saving more money is ALWAYS better. I think each investor should be as aggressive as their risk tolerence allows, and save as much money as they are able. An investors risk should be a function of the timeline, not of the contribution amount. Trying to convert one into another just doesnt work.

  6. It might be only 2% of salary more, but you are in fact talking about 50% more savings right? You can take less risk (or pay higher fees) if you are willing to invest 50% more.

    I’ve been on the committee to revise the 403(b) at our university lately, so I’ve been talking to a lot of colleagues lately about their savings plans. I suppose that it probably doesn’t represent many folks that frequent this blog, but I’ve found a lot that are probably paying 1.5-2% in unnecessary fees.

    Now, if your broker/salesman got you out of stocks 9 months ago and saved you from the turmoil this year, I’d say you might be getting something for your 1.5% of assets. But if your portfolio tanked like everyone else’s….

    After 30 years, 1.5% of extra fees will leave you 20% poorer. Or in the context of this discussion today, you’ll have to take a good deal more risk with your investments (or invest substantially more) to hope to do as well.

  7. Agree that saving more is always good…but I think the point here is that Diversification is important…

  8. @Nuri
    I’m not 100% sure where Jonathan stands (I would think he agrees with the Vanguard article), in which case you’re actually agreeing with Jonathan. The upside is obviously going to be higher with a more risky scenario (option 2, 100% stocks @ 4% contributions). I agree that risk is relative to timeline but also the investor’s own risk tolerances. I also agree risk absolutely should not change because of contribution amount. Many people think like this (“I’m behind in my retirement savings, I better amp up my equities to catch up”) and this posting hopefully will change a few minds regarding this train of thought.

  9. I’ve heard this type of argument before, if you only save a little bit you require higher returns to build your nest egg. By saving more money you can achieve your nest eggs goals with a balanced portfolio, you don’t need one that tilts towards high risk/high return.

  10. Bob – I don’t know if both those periods are 20 years (?) but you are right, there have been 20 years of low after-inflation returns for plain US Market. However, a diversified portfolio between more asset classes would have done better. If you look 30 years out, the numbers smooth out. For the young, we have decades until 65. But yes, that is part of the risk of investing.

    bob (lowercase) – The risk (besides the above) is also the panic you see when the stock market drops 40-50% in one year, with articles about people putting money under their mattresses. That money will often go back into the market it has jumped back up, which hurts your overall returns.

    Bill M – Agreed. My position is that I like to present all the options for those willing to consider them, because I think many people don’t even consider the options and just go for whatever the default is.

    Ron – I don’t think they are “screaming buys”. I’m just trying to take advantage of the 401k and/or IRA limits because they expire after Dec 31st. That $15,500 of tax-deferred 401k money each year is precious!

  11. Nuri – I think an investor aggressively should be based more on their need to reach their goals. As I get closer, I plan to get much more conservative. If I could buy an investment that guaranteed a 4% real yield forever, I’d take it in a heartbeat right now and give up the chance to earn 5 or 6% real yield.

    Don – You are correct, 6% is 50% more in this case. Saving 50% gets harder the more you already save. But it’s just one example.

    Expenses are a huge factor, I’m glad you’re trying to address that. That’s why I’m pretty limited in my 401k/403b investment options.

  12. the point i took from the article was that you should consider going from 4% contribution 100% stocks to 6% contribution 50/50 stocks.
    since they yield the same final result, but have less short term movements.

    If 1) your timeline is indeed 30+ years like the graphs dictacte, 2) you wont be scared out of any market (including this one), 3) you can afford to put in more money, and 4) your risk tolerence is such that you were correctly in the 100% stocks to begin with, then

    you shouldnt switch to 50/50 allocation, you shoudl stay in the 100% stocks because you were comfortible there to begin with, and putting in more money should net you a bigger return on investment.

    if however one of those 4 points is not true, then you should rethink your risk, your contribution level, and how much you look at your portfolio

  13. T rowe price pitched a similar argument my way and I hit a homer outa the park.

    I do the no cost monthly auto purchase 2050 of $50, cause I’m broke but I make myself. It strongly urged me to double my monthly investment to $100 and then showed me a graph showing how much faster my money would accumulate. While I can’t argue with statistics, I just cannot put more money away than I already do. My girlfriend only lets me cook lentils so often.

    I am almost ready to cash out that fat TDAmeritrade account with the $100 bonus after a year of savings. It’ll be fun to find a good place to invest some of that saved money. (and to not have the monthly checking deduction) – actually come to think of it, maybe now I CAN double my savings rate, or I already was and just didn’t think about it.

  14. The difference between 4% and 6% contributions shown in the plots above simply demonstrate the power of compound interest. A much better illustration of compound interest would compare different starting age of contributions. I keep telling my friends this principle, but they don’t get it; living frugally while you are young and saving/investing at a young age is paramount.

    Conversely, compound interest against you in the form of debt is incredibly scary. I still can’t fathom why intelligent people carry a balance on credit cards (short of an unforeseen emergency and only after exhausting other options).

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