As risk-averse as investors have become since the recession, a lot of people remain fixated on returns. They look at their approaching retirement and judge their holdings on the percentages they produce over one-, five- and 10-year periods. That’s not the way pension fund managers look at it, though. They focus on preserving as well as increasing the wealth in their care. And research by a major investment firm shows why chasing returns may not be the straightest path to financial freedom after all.
In 2011, The Vanguard Group published a report that concluded saving early and setting aside more money every year had a much greater impact on retirement savings than returns. Maria Bruno, a senior investment analyst, looked at a 25-year-old who earned $30,000 a year. If he invested 9% of his income in a portfolio of 50% stocks and 50% bonds and his income increased 1.1% every year, he would have $539,000 at age 65. If the same person instead invested a little less each year (6% of his income) in a portfolio weighted 80% to higher-returning equities and 20% to bonds, he would only have $469,000 at retirement.
In another study, Bruno determined that someone who saved $5,000 every year with no increases would, at a 4% return, need about 70 years to reach $500,000. An investor who increased his savings rate by 5% a year, by contrast, would need about 35 years to reach that mark. Someone who increased contributions by 10% a year would reach that figure in just 20 years.
Chasing returns doesn’t work, she says, because investments are volatile, and there’s no such thing as a guaranteed return. As well, compounding plays a much bigger role in savings growth than how much you can make in the market in any given year. “It’s earnings on earnings, and that has a snowball effect,” she says.
The point, says Bruno, is that investors should focus less on returns and more on boosting their savings every year. If your income is increasing even gradually, then that shouldn’t be hard. Automatically up your RRSP contribution by even 1% annually, she says. “Do it automatically and you can increase it without having to make a conscious decision to save more.”