Importance of saving rate

In , saving 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 saving rate).

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

To put the saving 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 saving 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 saving was only 4% will have saving of $336,510 at the end of 30 year period.

The increase in saving rate is crucial particularly if the return on investments is low. However if return on investments are very high, then the impact of saving rate become relatively less important. Alternately, if the saving rate is less than 4%, the saving rate has huge impact on the end balance over the rate of return.

Table 1 below will help visualize the relation between saving rate and return on investment for given saving rate. For example, with a saving rate of 1%, a 12% return on investment is necessary to save $241,334. Whereas, for a saving rate of 2%, a return slightly over 8% will suffice to achieve the same end balance of $241,334.

In the initial phase of accumulation of wealth, saving 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, saving rate is more important than returns. Morningstar had recommended some suggestions to increase the saving rate.