In this topic we will be discussing the principles of meeting your objective via saving or via investing. We will put the conventional theories to the test and determine which works better over the worst possible case of a short (< 5 year) window of time.
Before we start investigating saving vs investing, let’s talk about objectives or goals. Let’s delve a little deeper into goal setting theory.
Let’s Visit Goal Theory
If we look back at research conducted by INTERNATIONAL JOURNAL OF MANAGEMENT, BUSINESS, AND ADMINISTRATION VOLUME 15, NUMBER 1, 20111Goal-Setting Theoryof MotivationFred C. LunenburgSam Houston State University
Based on this article, the author stated that the following characteristics of our goals need to exist for them to be successful.
Based on the findings, goals should be:
- Goals need to be Specific
- Goals should be Difficult but Attainable
- Goals must be Accepted
- Feedback must be provided on Goal Attainment
- Goals are more effective when they are used to evaluate performance
- Deadlines Improve the Effectiveness of Goals
- A Learning Goal Orientation Leads to Higher Performance than a Performance Goal Orientation
- Group Goal Setting is as important as Individual Goal Setting
Now, if we take these principles and apply these to personal finance, we can derive the following adjustments.
Adapting this goal framework to Personal finance, your goals could be:
- Goal should be a specific amount of money
- Goal should be a stretch to meet, but not impossible – Choose a realistic amount of money
- Goal should be accepted – Review your goal with other stakeholders
- Feedback should be taken on the goal during the process – Sanity check your goal; be realistic in your target
- Goals are most effective when evaluating performance – Conduct timely “check-ins” of your goal – Are you on target?
LAB Test – Hypothetical Scenario
Therefore, using this goal framework, let’s create a hypothetical scenario with a sample goal that meets the above criteria: “I want to save $10k before the end of the year, broken down to $833.33/month or $192.30/week and I currently make $75k per year gross income and I will review my progress monthly.”
Based on this example, the goal provided above is specific, stretch, acceptable, feedback and can be evaluated. Now, that we have a sample goal that meets our goal theory targets, let’s delve into the next step and see if we can achieve this goal either by saving or investing?
Using the Savings Method
In personal finance there are two general ideas of thought schools of teaching when trying to meet our goals. The first school of thought is to try to save our way into meeting our goals – You will see this method proposed by many financial blogs and websites; save $1 on coffee, cut your own hair, etc. While these tips are not bad in themselves, you will see how savings works towards meeting our “Lab Test” goal.
Therefore, based on our hypothetical income of $75k/year (see above) we have an after tax net income $52,500.00 – this equates to $1,009.62/week in net income. If we assume that we utilize a brute force savings method to try and meet the $10k goal and don’t put any money in the bank (not recommended), this makes our goal of saving $192.30/week or approximately 19.0% of our net income; a very high savings percentage indeed!
If we refer to the OECD, we see the personal savings rate for USA at 6.9% (2017) and CAD at 1.97% (2017) – See chart below. Both of these savings rates fall far below the required 19.0% savings rate of our hypothetical goal above. Based on this analysis, we haven’t even considered the cost of everyday living which is likely higher than 81% of net income for most individuals.
Now, if we apply the OECD savings rates of 6.9% USA ($3,622.52/year saved) and 1.97% CAD ($1,034.25/year saved) to the $10k hypothetical goal, we see that based on Savings Rate alone we can achieve our hypothetical $10k savings goal in 2.76 years (USA) and 9.67 years (CAD).
Therefore, based on this information, it appears that our goal is not achievable in 1 year through the savings method alone – Either this is not a realistic goal or further work is required; perhaps reduce the current cost of living and expand our savings rate?
Using the Investing Method
The second school of thought surrounds investing – With investing, you still need to work diligently to save money but you also use the power of the stock market, bond market and real estate (more on these topics in future blog posts) to accelerate your efforts in growing your money. Let’s see how investing works towards meeting our “Lab Test” goal.
Now if we use investing as the method to meet our $10k goal, we will apply the following simple assumptions: Rate of return by investing is 8%; based on historical return of S&P 500 over 1957-2018. This is not ideal for long term investing due to volatility and portfolio risk; but for this example it will suffice.
The average annual return since adopting 500 stocks into the index in 1957 through 2018 is roughly 8%.Investopedia
Therefore, based on our hypothetical income of $75k/year (see above) we have an after tax net income $52,500.00 – this equates to $1009.62/week in net income. If we use the investment return of 8% and target to meet our best timeline from the savings goal above at 3 years (USA savings) we determine that the savings goal required is now $256.69/month for 3 years or $59.24/week. In one word, WOW!!
Based on a quick analysis, using the 8% rate of return and the investing method, we see that we have reduced our savings burden from $192.30/week (savings only) to $59.24/week (investing). See the chart below for validation of this calculation.
If we apply this back to the original problem, this equates to 5.86% savings rate in our original example, vs the 19% as previously calculated. This overall savings rate experienced through investing included a reduction of 70% of the amount required, by letting the market do the heavy lifting of growing our money with only 3 year limited window of time!
Based on this simple analysis, we see that the market has provided an additional contribution of 70% more power to our savings rate with minimal impact to our everyday cost of living and savings rate. Based on this the calculated savings rate of 5.86% vs 19% is far more achievable within the USA and CAD without impacting our finances too much. Moving forward, we can see that even a measured increase in the amount saved and time in the market can increase your yield substantially; more on this to follow in future posts.
Note: We realize this is a very simplistic view of saving and investing, but the power of the simplicity still applies; more detail to follow on future posts regarding risk, asset allocation, market returns. As always, please contact a certified financial adviser before making any changes to or beginning any investing on your own as your circumstances are unique.
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