It only has three ingredients. And that’s true whether you’re Warren Buffett or a school teacher. It doesn’t matter how much you make. The three things needed to build real wealth don’t change.
Here they are–Savings, Return, and Time. That’s it.
- Savings: How much you save each month or year;
- Return: Your after-fee rate of return; and
- Time: How long you invest
What’s interesting about these three factors is that most people obsess about the first one. We focus on how much we save, or don’t save, but give little attention to return or time. We worry over whether we can add an extra $50 a month to our 401k or IRA, but give little thought to the expense ratio of our mutual funds or paying an expensive investment advisor one percent or more.
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We also don’t obsess about the time, particularly when we are young. It hardly seems important to start investing at 25. What’s the big deal of waiting until we are 30, or 35?
How much we save is of course important. But return and time are the two factors that drive real wealth. Like the Fight Song, “I might only have one match, but I can make an explosion.” What we save is the match. Return and time are the explosion.
In this article we are going to look at five “experiments” that will show these three ingredients at work. To begin, let’s set a baseline. Let’s assume a family making $100,000 a year saves 20%, or $20,000, for 40 years. Let’s also assume they earn a 10% return (yes, higher than I would assume for planning purposes, but be patient).
How much will they have after 40 years? $8.8 million, give or take.
Before we get to our five experiments, let’s look at this $8.8 million a little more closely. There are two key things to keep in mind here. The first is what I call the Iceberg Effect. Of the $8.8 million, only $800,000 of it represents contributions from savings ($20,000 a year x 40 years). The vast majority of the wealth built in our hypothetical comes from returns on our savings and returns on our returns (i.e., compound interest).
The second is what I call the Snowball Effect. It’s similar to the debt snowball, but here we are building wealth with it, not paying down debt. To see the Snowball Effect more clearly, let’s breakdown the $8.8 million by decades. Here’s how much our wealth grew in each of the four decades:
Decade 1: $318,000
Decade 2: $826,000
Decade 3: $2.1 million
Decade 4: $5.5 million
The point here is to show with actual numbers the power of time. A key reason Warren Buffett has the wealth he does is because he’s lived into his 80’s. Had he died at the age of 59, he would have “only” been worth $3.8 billion. A lot of money, to be sure, but a far cry for his current wealth of more than $60 billion.
Now on to our five wealth experiments.
Experiment #1—Amount vs. Time vs. Return
What’s most important, the Savings, Time, or Return? They all are important, of course. But let’s reduce each one-by-one by 10% and compare the results. We’ll first reduce the amount we save each year by 10%, from $20,000 down to $18,000. Then we’ll reset the Savings back to $20,000 and reduce the return by 10%, from 10% down to 9%. Finally, we’ll reset the return back to 10% and reduce the time by 10%, from 40 years to 36 years.
Any idea which one will have the largest effect on our results? Here you go–
$18,000: $8 million
9%: $6.6 million
36 years: $6 million
How much we save is important. But for long time investors, it’s Return and Time that drive wealth.
Looking a little deeper into Return, we are going to compare two hypothetical families. We have our 6-figure family that makes $100,000, saves $20,000 a year for 40 years, earning 10%. Let’s compare them to the 5-figure family. This family makes $50,000, saves $10,000 a year for 40 years, earning 10%.
The results so far are predictible. The 6-figure family will end up with twice as much as the 5-figure family: $8.8 million versus $4.4 million.
Now, how much would we need to reduce the 6-figure family’s return such that they would end up with the same amount as our 5-figure family. Since the 6-figure family is saving twice as much, it may at first glance seem that they would have to earn a lot less than 10% to bring their total savings down to $4.4 million after 40 years.
Here are the results for the 6-figure family based on different Return assumptions:
7%: $4 million
7.5%: $4.5 million
So just a 2.5% drop in return turns the 6-figure family into the 5-figure family, even though they saved 2x for 40 YEARS!
There are many seemingly harmless decisions that can reduce our after-fee returns by 2.5%. These including hiring an expensive investment advisor, investing in expensive mutual funds, an asset allocation plan that is too conservative, and changing our investment plan out of fear during bear markets.
Let’s try the same experiment, but this time we’ll change how long our 6-figure family invests. How many years would they need to delay to bring down their nest egg from $8.8 million to $4.4 million? Seven Years. Delay just 7 years and the result of saving $20,000 a year is the same as saving $10,000 a year for the full 40 years.
Experiment #4—Time & Return
Now let’s combine both Time and Return. Let’s reduce both for our 6-figure family to see how seemingly small changes can have a big impact. Because we have two variables to play with, the changes do not have to be significant to reduce the 6-figure family’s net worth down to the $4.4 million figure.
In fact, if this family delays just five years (investing for a total of 35 years) and reduces their return by 1% (paying this amount to an investment advisor, for example), their $8.8 million drops to just about the $4.4 million our 5-figure family earns.
Experiment #5—Time & Return & Asset allocation
In our last experiment, let’s add the results of an asset allocation decision. Let’s assume our 6-figure family goes with a “safe” 60% stock and 40% bond portfolio. Data complied by Vanguard tells us this portfolio will return about 8.8%. Now let’s subtract a 1% advisor fee and assume they delay just three years. We’ll assume they starting saving at 28 instead of 25. Doesn’t seem like a big deal.
Just these seemingly innocent decisions once again reduce their result from $8.8 million to $4.4 million.
The point: How much we save is important. Check out this calculator for a simple way to determine how much you need to save to achieve financial freedom at any age. However, return and time are critical too. Even a few “minor” mistakes can wipe out a huge portion of wealth, even for those super savers among us.
Here are the five key takeaways:
- The amount we save is just 1/3 of the equation. Never, ever, underestimate the importance of time and return.
- Start saving today, even if it’s $25 a month in your 401k or in an account at Betterment.
- Understand the importance of the stock/bond allocation decision. It’s NOT just about your tolerance for “risk” (i.e., volatility).
- Think long and hard before paying somebody to put your money in mutual funds for you.
- Watch those expense ratios. The important number is the weighted average expense ratio.