The Scrupulous Saver v. The Savvy Investor

We’ve been talking a lot lately about the relative importance of financial behaviors as compared to other factors such as investment returns. I have advanced the idea that saving copious amounts of money is more impactful for your long-term wealth accumulation than investing prowess, and I thought it was time to add a bit of quantitative analysis to the discussion. 

Before nerding out with spreadsheet inputs and outputs, lets clarify a few conceptual items. I am not making the case that investing isn’t important. To the contrary: investing and thereby leveraging the power of compound growth—one of the most powerful forces in the cosmos—is an indispensable part of achieving financial independence. If you’re a kick-ass saver that stashes all your cash in a coffee can, you’re going to make your journey to independence much tougher and longer. The point I’m making here, and the philosophy that I’m advancing, is that investment returns should essentially be viewed as a commodity that is now available to everyone (with little effort), which reduces the critical variables down to one: your savings rate and how much you can feed into the investment machine that will provide those (hopefully) juicy returns over the long-term, accelerating your trip to Freedom. 

Understand that a whole lot of big-salary dollars (and beach houses in the Hamptons) are dependent upon the effort to convince you and me that saving doesn’t matter because you’ll overcome and get ahead by picking the next hot stock/fund/ETF. The rise of index investing is slowly but surely chipping away at this fallacy, but it’s still out there and it’s mutating into different forms (see our discussion of active-indexing). And too many people, I fear, are reading the index-investing movement erroneously by concluding that the index ETF is itself the next hot investment that will overcome a lack of savings. Wrong.  

The reality is this: once you accept/realize that investment returns for most of us have been commoditized (that’s good), you have reached a stage of financial enlightenment where you see with absolute clarity that your financial behaviors matter more than your investing prowess. When we talk about “financial behaviors” we’re talking about things like savings/consumption patterns, buying high and selling low (the creator of the “behavior gap” in our investment returns), and discipline and responsibility in managing your financial affairs (regularly doing things like monitoring expenses, tax planning, etc.). Today we are focused specifically on the 800-pound gorilla of spending and consumption patterns. 

A Tale of Two Attorneys: Joe and Barry

Let’s create a hypothetical story of two corporate attorneys, identical in every economic respect except for: (1) their savings rate and (2) investment portfolio selection and performance. Both graduated from law school and got jobs as associate attorneys at top law firms where they earned a starting salary of $100,000/year (before bonus) beginning in 2000. 

Attorney Joe earns market returns (US domestic stock market) less small marginal costs through index-fund investing, but is disciplined enough to save 25% of his healthy attorney salary every year. Why 25%? It’s a strong-but-achievable figure: if Joe simply maxes out his 401(k) ($15,500), an IRA (traditional or Roth) ($5,500), and an HSA (family limit of $6,850), he’s already north of 25% of gross income. 

Attorney Barry works hard in his investment activity and is able to best the market every single year by 4%. He’s shooting the lights out on a consistent basis. But he’s only saving 7% of his annual salary. Why 7%? As of April 2018 the average personal savings rate in the US stood at just 2.8%, and that’s 2.8% of disposable income, not gross income. Since we’re talking gross income here today, let’s convert that savings rate figure from disposable to gross. Assuming a 30% effective tax rate for Barry, he would have $70,000 of disposable take-home pay after taxes. The 2.8% savings rate would yield $1,960 of savings, or only 1.96% of his gross of $100k. Here’s the calculation:

So the 2.8% average savings rate becomes 1.96% when applied to gross income. That’s the national average. But Barry’s not average. He’s an attorney after all, working at a BSD law firm. He’s at least 3x better than average. Wait, he drives a recent-model Range Rover. Okay, he’s 350% of average. So we’ll assume a 7% savings rate, just to give him a fighting chance. 

Here’s a 10-year chart of average US personal savings rates (again, based on disposable income):

Barry’s a smart guy, educated at an Ivy League law school and carries the six-figure debt load to prove it, so he knows the difference between net and gross, and thus he knows that his 7% savings rate is well above the national average. He goes to sleep at night with a smile: he’s a hot-shot investor (the data tells him that!), so he doesn’t need to save as much as Joe who spends his days (and most nights) in the office next door. Barry knows he’s smarter. Saving is for the ordinary suckers. 

Random Notes and Assumptions Before Diving Into the Spreadsheet

Understand that Barry’s 4% market-beating return year after year is huge. Not a small feat. We’re even going to assume that the 4% delta is after investment fees. Based on this performance Barry should leave the practice of law and go to Wall Street where he would earn tens of millions of dollars every year as a hedge fund manager. (Recall that we’ve recently looked at this data in the context of the proportion of actively managed funds that beat the market over various time horizons. See here.) In the real world Barry is highly unlikely to be able to beat the market by 4% a year, every year, over any significant period of time. But notwithstanding the improbability, we are stipulating this fact here to further our academic purpose. 

Joe and Barry both started at the firm in 2000 earning a $100,000 annual salary at age 25 (hmmm, looks a bit like me). They receive the same annual salary increase of $15,000 (again based on real life), and we’re going to exclude bonuses from the calculation (they would be identical if we included them, obviously). 

Next we will assume an annualized total return (i.e., including dividends) for the market of 8.5%. That means Barry’s returns are 12.5% per year. 

The Results (Spreadsheets Are Fun)

So what do Joe and Barry’s bank accounts look like in 2018 after 18 years of working, saving, and investing? Before peeking below, if you haven’t already, take a second to formulate in your mind what you imagine their different results will be and the order of magnitude of any difference. Review the variables: Joe saves 25%, Barry 7%. Joe gets market returns of 8.5% each year, Barry gets 12.5% (almost 50% more than Joe). 

After 18 years Joe has accumulated $2,087,318, and Barry has $846,105. Barry has accumulated only 40.54% of what Joe has accumulated (the “Barry/Joe ratio”). 

I don’t know about you, but that disparity surprised the hell out of me (after all, I undertook this exercise thinking that I knew what the general result would be, but not the magnitude). 

Okay you say, that’s fine, but as their incomes grow and time goes on Barry’s out-size returns will compound even more and he’ll catch Joe and surpass him, right?

It is the case that with more time Barry’s returns will compound at a greater clip and he will start to narrow the gap and increase the Barry/Joe ratio, but not as much as you might think. Here’s where Joe and Barry are after 30 years of working, saving, and investing:

So now Joe has $7.879 million and Barry has $4.324 million. The Barry/Joe ratio is up to 54.88%, but I’ve got to be honest here: if I’m Barry I’m pissed the f*ck off. (Did I mention that Barry drives a Range Rover? With a strut package? Holy hell.) 

And here’s the kicker that may drive Barry and his Range Rover off the cliff: even if Joe never saved another dollar after year 18, and never did anything other than take the 8.5% that the market gave him over the next 12 years (reaching the 30-year time horizon), Joe would still have more than Barry. The $2.087 million that Joe had accumulated by year 18 grows to $5,555,785 after 30 years at 8.5% without ever saving or investing another dollar. 

Alternatively, if Joe decided to retire after year 18 and live off of 4% of his $2.087 million stash (while maybe, I don’t know, foregoing daily traffic jams and staying home to brew craft beer), he would still be sitting on $3.539 million in Year 30—that is, compared to Barry’s $4.324 million after working another 12 years at the law firm. (Here I’m just reducing the annual rate of return for Joe for years 18 to 30 from 8.5% down to 4.5% to build in a 4% withdrawal rate. Obviously this eliminates the potentially huge impact of sequence of returns.)

Other Relevant (Miscellaneous) Considerations

Because Joe is able to save 25% of his gross income beginning in year 1, he should have no problem carrying that forward in future years as his income increases. In fact, since he has the saver’s mindset and some amount of frugal DNA, Joe is more likely to increase his savings rate in the later years as his income increases and he successfully resists the siren song of lifestyle creep. 

I used the annualized total return of 8.5% based on a very rough look back at how the Vanguard Total Stock Market Fund has performed over the period 2000 through the end of 2017, and tacked on a 2% annual dividend yield to achieve annualized total return (again, a rough calculation). I didn’t calculate this return figure with precision because as I played with the spreadsheet input I saw that it didn’t change the result in terms of the disparity between Joe and Barry as I assumed it might. As I move the market return figure in either direction (going down to 5.5% or up to 10.5%, whatever), the Barry/Joe ratio stays the same at right around 40% (it jumps to 41% at 11.5%). 

The inescapable conclusion from this analysis: whether investment returns go up or go down over time, we get the same result. The scrupulous saver beats the savvy investor. Big time. 

The Point of This Exercise

First, let’s be honest, spreadsheet what-if games are fun. 

But after that, the point of the exercise is to make the argument for where you should focus your efforts as you consider trying to reach financial independence. Investment returns have been commoditized—thank you Mr. Bogle and Vanguard—and market-average returns are available to everyone (and will, strangely enough, ultimately be above average). The steps are: Buy. Hold. Don’t panic. And you will earn what the market gives you. 

But you can’t control what that return will be. Maybe it’s 5.5% over the long-term. Maybe it’s 10.5%. Who knows. I don’t. I bet you don’t either. (Note: If you think you do, you might want to consider focusing on Barry’s numbers.) 

But you can control how much you consume and how much you save. That is almost entirely within your sphere of control. And that factor—which you control—has a disproportionately large impact on your future wealth and therefore your future Freedom.