The Best Way to Maximize Your Investment Return

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There are three basic variables that impact the total return your investments generate. They are:

• Amount saved -- The amount of money you save every year.
• Return rate -- The rate at which your money grows.
• Time -- The number of years that your money is allowed to grow.

All of these are important and we talk about them frequently, but which is MOST important? Well, I developed a quick spreadsheet, ran some scenarios, and wanted to offer my findings to you. (But before I do, anyone want to guess which one has the biggest impact on the outcome?)

To begin this process, I had to make assumptions about a person's saving/investing to get a baseline investment return. Here's what I assumed our mythical person did with his investments:

• Earned $50,000 a year and saved 10% of that (or $5,000) per year.
• Earned an 8% total return after fees, taxes, etc.
• Invested for 30 years.

Using these assumptions, I found that this person would have $566,416 at the end of 30 years (FYI, I used this calculator to check my numbers.) In other words, $5,000 saved per year at 8% for 30 years generates $566,416. Pretty simple, huh? (BTW, I assumed that the money invested did not earn anything in the year it was invested. It started earning in the next year.)

Next I started tweaking the variables one at a time, leaving the others the same, to see what the impact would be. I tried to pick increases that I felt were comparable. In other words, I assumed that it was just as easy (or difficult if you prefer to look at it that way) to save $1,000 extra per year as it was to earn an additional 1% per year as it was to save for five extra years. I'll comment on how valid those assumptions are in a minute, but for now here are the results:

• I increased the amount saved to $6,000 per year. $6,000 per year at 8% for 30 years equals $679,699 or a 20.0% increase versus the original result.

• I increased the return rate to 9% per year. $5,000 per year at 9% for 30 years equals $681,538 or a 20.3% increase.

• I increased the time to 35 years. $5,000 per year at 8% for 30 years plus an addition 5 years of growth (but no extra investment) equals $832,251 or a 46.9% increase.

So, when you increase the amount saved by 20% per year, your overall increase is 20%. This seems to make sense and be "fair." But if you increase your return rate by only 12.5%, you get a 20.3% increase in the total, a much better result. Yet when you save for an additional five years, a 16.7% increase in time, you get a much, much better return -- an increase of 46.9% total. Quite interesting, wouldn't you say?

Now it would be easy to declare time the winner, rate second, and amount third, but a few other things have to be taken into account:

1. In reality, saving an extra $1,000 isn't comparable to earning an additional 1%. Earning that extra percent is a lot harder. So while the rate increase delivers more, it's much more likely that you'll be able to save more, thus I'd place the amount saved over the return rate in importance.

2. Time saved really is the winner. In fact, if our mythical person saved for only two extra years instead of five, he would have earned about as much as the 1% increase in the rate and $1,000 extra. Therefore, IMO, it appears clear that time saved is the most important factor in investment returns.

3. The good news: the two most important factors in determining a good investment return are ones that we have the most control over. It's much easier to add extra time (by putting off necessary withdrawals and starting as early as possible) and the amount saved (increasing income/decreasing expenses to save more now for investing) than it is to try and earn an extra 1%.

4. That said, you can't buy extra time. You can keep extending it on the back end as much as possible, but if you're 50 years old, planning to invest and let your money sit for 35 years isn't a realistic option. So for older individuals, I think the amount saved is the most important factor in maximizing your investments.

5. Yes, there are some flaws in this simple analysis. For instance, most people don't earn $50,000 starting in year one. Thus it would probably be hard for them to save $5,000 in year one. Furthermore, people start earning as soon as they invest, so the actual numbers are a bit higher (though for comparison sake they are all accurate here.) And investments don't earn return rates in a straight line, they vary from year to year. Finally, I had to make several assumptions that will likely be different than the actual scenario for any specific individual. So sure, there are things that could be changed, but this analysis does give us a good view on the comparable impact of the three factors.

6. If you do all three -- increase the rate to 9%, increase savings to $6,000, AND increase time to 35 years -- you really get a huge impact. The amount at the end of the 35 years grows to $1,294,265, 129% more than the initial scenario. That's why people spend so much time trying to increase all three of these, because if they can, the payoff is really big.

Now, on a personal note, here's what I'm doing to make these three factors as high as possible:

• I'm saving/investing as much as I can each year in a variety of ways. For details on what I'm saving/investing, see I'm Still Buying.

• I'm doing all I can to maximize my return rate -- investing in index funds in the lowest cost alternatives I can find.

• I'm going to postpone withdrawing funds from my savings for as long as possible by working part-time once I "retire". For details on why I think I can do this, see What I Plan to Do During Retirement.

I realize that much of the information here is not new news to seasoned investors. But for those just starting out (especially new grads that have a chance to save for 35 years) or those unfamiliar with how investing works, I thought this information would be insightful.

For those of you who are more advanced investors, I'd appreciate your thoughts/comments on this analysis. It's likely that your perspective will make this piece better, so I'll look forward to your comments below.

Comments

[Ron]

Excellent post. Whats the saying, "Time heals all wounds." I think thats how we have to look at the current financial situation.

[Sarah]

Something that should be impressed on novices about these calculations: 4% (max recommended drawdown) of $566K is only about $23K (before taxes, if money is in a 401(k), obviously not an issue if it's a Roth). If no Social Security in retirement (all too likely), that's a 50% reduction in income from original salary. Ouch! Even on the 35-year plan, you're still only getting $33K a year. And we haven't even considered inflation.

Conclusion: everybody needs to save more!

[TJ]

What are some less risky investment ideas to earn 7, 8 or 9% rate of returns?

[FMF]

TJ --

Here's what I do:

http://www.freemoneyfinance.com/2007/03/why_i_like_inde.html

[Mark C]

Don't forget about using inflation to your advantage.

A $1000 saved ten years ago was worth more then than it is today. If you save a set amount every year from now on instead of a percentage of your gross salary, your real rate of return is higher because it's less a percentage of your income. Although the value of a dollar is decreased due to inflation, the earlier the compounding starts on older dollars, the better.

Of course, it's still better to raise your contributions as a percent of your gross, BUT, like paying a fixed mortgage payment, over time it's less of a burden if you want the spend the difference on other things. Thanks to my fixed mortgage I took out fifteen years ago, I have more left over to invest.

[Mark C]

I often see other on this board brag about their investment returns, like getting 10-20% year after year, which I fail to believe anyway. You're far better off sacrificing as much as you can early on in life to invest long-term (like index funds or some other safer investment) than trying to trade stocks or commodities. Any good financial calculator will prove that the biggest influence is how much you save and how early you start saving, not whether you get 6% or 16% return. Furthermore, what is the value of your time and health spent chasing returns? If you don't value having too many things, you won't miss not having them, which in turn makes saving a significant portion of your earnings no burden at all.

[Mike Hunt]

What I learned is you can't take returns for granted. When you get them be grateful for what you've received. Money doesn't just multiply like rabbits, it takes some careful decision making, planning and luck.

Since I started my career in the mid to late 90's my average returns have been less than 0%. I still managed to build a high net worth though by saving.

-Mike.

[F]

You indeed do need luck with the stock market. There are these 10- or 20-year-long waves in P/E ratios. In the period 1980-2000 we had rising P/E ratios, so even your grandmother would have made a profit in the market (and thought she's a pro at investing!). The last decade has been different - could be the beginning of a wave down. In such a period it's difficult to make a profit in the short term (10-20 years), which might be what Mike has experienced.

[Mike Hunt]

F,

Good comment. Indeed this has been a lost decade. I'm convinced that the demographics in the US (baby boomer retiring and pulling their money out of the stock market) coupled with our country's high debt / low interest rate policy will depress stock P/E's for another decade or two. I think there are still trading opportunities to jump in and out of the market but I think buy and hold is a terrible strategy for the next 10 years.

-Mike

[F]

Mike,

I agree with you on Western markets in general, but on the other hand the market has already fallen back a lot so it's worthwhile to check for individual stocks whether they aren't worth buying, based on 'normal' but conservative earnings and a low P/E. I think the earnings of commodity stocks are a lot more likely to recover than those of the S&P 500. This upside potential can make up for P/E damage. Anyway, you've got to run the numbers. A very conservative estimate for e.g. BHP Billiton (ADR) would be $30, based on E/P=7, 12bn profit (2006 level + synergies from their latest deal). With either E/P=10 or the 2008 profit levels (why not - tight supply should sustain high commodity prices), I arrive at $42. We're higher now but we've been there (below $30). Add to that nice growth prospects (emerging markets) and you see why I would buy a stock like this provided their price drops again to the above levels.

The S&P 500 turns out less attractive (roughly $400) because here I took 2004 earnings (what came after that might have been a credit-driven earnings bubble). I don't see us test $400 any time soon, plus no emerging-market growth prospects.

I haven't done the exercise for emerging markets yet, but it's definitely worth it. If anyone has, feel free to post.

[F]

Typo: P/E, not E/P

[Jeff Cohen]

less risky ways to earn 7-9%on your money

Master Limited Partnetships (MLP'S) These are pipeline companies traded on the ny stock exchange. they get paid based on the amount of oil/gas moving thru the pipe not the cost of the oil so their profits are fairly steady. The pay dividends of 7-10% that tend to grow over time.
The MLP's also have the dvanrage that most of their dividend is tax defered do to a quirk in the tax laws for oil/gas pipeline companies. Because of this quirk they are really not suilable for retirement accounts and they tend to make tax return time a little more complicated since you get a k-1 instead of a 1099. Some of the big pipelines are PAA,OKS,KMR,TPP,ETP,EPD.