Be grateful for your delayed gratification
Thanksgiving is about being thankful. We all should take some time to be thankful for what we have regardless of whether or not we celebrate this American holiday tradition.
The entire process of investing is about sacrificing current consumption for future consumption. Any solid and sensible investment strategy should do the same. Ultimately, to make money you have to be willing to trade off some comfort now for increased comfort later. If you have been a saver and investor for the past few years you can be very grateful for your delayed gratification. So how much does saving more help? Quite a bit actually.
The easiest way to ramp up your wealth is of course to delay more gratification and simply save more. Daniel Kahneman has shown in his book “Thinking Fast and Slow”, that we get twice as much pain from the feeling of losing money as we do from the enjoyment of winning money. This is one of the biggest reasons people have difficulty saving enough to achieve their goals.
We don't like to lose out on spending money now to putting money in our savings and investment accounts. Tweaking your asset allocation balance yearly or finding better and cheaper funds may make you feel like you are doing something to increase your performance but these tend to be marginal improvements at best.
Generally, the rule of thumb for investors has always been that a stock-heavy portfolio is much more volatile than one that holds a higher weighting in bonds. Perception plays a huge role in how investors view portfolio risk, but lower volatility tends to make investors feel safer and thus these assumptions often prevail.
Let's look at a simple example to see another way to decrease portfolio risk over time. Assume a young person starts saving at age 30. They plan to save and invest until they retire by age 65, a 35-year time horizon to compound their money. Let's also assume that our hypothetical saver starts out making $60,000 a year, with three per cent annual salary increases for cost of living adjustments.
Using long-term return assumptions of eight per cent for stocks and three per cent for bonds, Table 1 shows the ending balances by asset allocation and savings rates.
What should stand out here is that saving more money reduces risk, either by allowing the investor to take less equity exposure or by increasing the compounded returns in a stock-heavy portfolio.
The ending balance for the 50/50 allocation under a 15 per cent savings rates turns out to be nearly as high as the 90/10 allocation under a 10 per cent savings rate. Jump up to a 20 per cent savings rate and a 60/40 portfolio is nearly in line with a 90/10 portfolio at the 15 per cent rate of savings.
Think of this another way — over 35 years at these assumed rates of return, a five per cent annual increase in savings would produce roughly one per cent per year in annual investment gains. This is a substantial boost over time and a boon exponentially.
Not many young people are able to start out saving 15-20 per cent of their income right off the bat. As a result we can see how the results would change if we slowly bumped up the savings rate each year by 1.5 per cent of the previous year's rate. So we start out by saving 10 per cent of salary in year one and increase it to 10.15 per cent the next year and 10.30 per cent the year after that and so on (ending up saving 16.84 per cent in the last year). The results are shown in Table 2.
The additional balance in the furthest column to the right shows the increase over simply sticking with a ten per cent savings rate for the entire period. Each of these balances saw a greater than 20 per cent improvement over the initial value that didn't include the incremental increase to the savings rate.
You can argue with the longer term stock and bond return assumptions, but they are impossible to predict looking 35 years out into the future. The investment performance is beside the point anyway. The argument is that saving more and delaying gratification reduces risk, regardless of if you define risk as owning more stocks or running out of money. That's one thing you can be thankful for.