Importance of saving rate

In , savings rate is compared with an investor's Return on Investment (ROI) in order to understand its impact on an investor's financial goals.

Investors often focus primarily on asset allocation, expenses associated with investments (such as transaction fee, expense ratios), tax efficiency (types of account), sector allocation, active vs passive etc, to maximize the return on investment to attain a financial goal. Further, the importance of saving early is also well documented.

Achieving an investor's financial goals is a combination of not only market returns, but the amount saved over time (the savings rate).

Savings Rate
Savings rate is defined as percentage of income saved by an individual or entity towards a financial goal.

To put the savings rate in perspective, let us say two investors A and B make $100,000. Investor A, saves 4% of income ($4,000) consistently for 30 years, with return on investment on savings at the rate of 6% will have $316,233 at the end of 30 year period.

However, investor B saves 6% of income ($6,000) but the return on investment on savings was only 4% will have savings of $336,510 at the end of 30 year period.

The increase in savings rate is crucial particularly if the return on investments is low. However if return on investments are very high, then the impact of savings rate become relatively less important.

Alternately, if the savings rate is less than 4%, the savings rate has huge impact on the end balance over the rate of return.

Table 1 below will help visualize the relation between savings rate and return on investment for given savings rate.

For example, with a savings rate of 1%, a 12% return on investment is necessary to save $241,334. Whereas, for a savings rate of 2%, a return slightly over 8% will suffice to achieve the same end balance of $241,334.

'''Table 1: Saving Rate (SR) Vs Return on Investment (ROI) for Savings. Assumptions: Annual income: $100,000. Future value calculated assuming money invested at the end of period for 30 years.'''

In the initial phase of accumulation of wealth, savings rate has the most impact in increasing the nest egg. The return on investment becomes important only after the nest egg has grown significantly or after it achieved a critical mass.

To achieve a financial goal, investor only have to control the savings rate rather than depend on market returns.

Thus to achieve a particular financial goal, savings rate is more important than returns. Morningstar had recommended some suggestions to increase the savings rate.