Why saving is for the poor and investing is for the rich
WHEN I WAS 23 years old I thought I knew the answer to building wealth. Keep your fees low. Diversify. Hold for the long term. I had heard this kind of advice many times from investing legends such as Warren Buffett, William Bernstein, and the late Jack Bogle. While this advice wasn’t incorrect, it made me focus on all the wrong things financially as a recent college graduate.
Despite having only $1,000 in my retirement account at the time, I spent hundreds of hours analyzing my investment decisions over the next year. I had Excel spreadsheets filled with net worth projections and expected returns. I checked my account balances daily. I questioned my asset allocation to the point of neurosis.
Should I have 15% of my money in bonds? Or 20%? Why not 10%?
I was all over the place. They say that obsession is a young man’s game. I learned this truth all too well.
But despite my intense fixation on my investments, I spent no time analyzing my income or spending. I would regularly go out to dinner with coworkers, buy rounds and rounds of drinks, and then Uber home. Spending $100 in a night was easy in San Francisco, where I lived at the time.
Think about how foolish this behavior was. With only $1,000 of investable assets to my name, even a 10% annual return would have only earned me $100 in a year. Yet, I was regularly blowing that same $100 every time I went out with friends! Dinner + drinks + transportation and my year’s investment returns (in a good year) were gone.
Forgoing just one night of partying in San Francisco would’ve made me the same amount of money as one year of investment growth at the time. Can you see why my financial priorities were so messed up? All the Buffett, Bogle, and Bernstein in the world wouldn’t have made a difference.
Compare this to someone with $10 million in investable assets. If they were to see just a 10% decline in their portfolio, they would lose $1 million. Do you think they could save $1 million in a year? Highly unlikely. Unless they have a very high income, their annual savings just can’t compete with the regular fluctuations in their investment portfolio. This is why someone with $10 million has to spend a lot more time thinking about their investment choices compared to someone with only $1,000.
These examples illustrate that what you should focus on depends on your financial situation. If you don’t have much money invested, then you should focus on increasing your savings (and investing it). However, if you already have a sizable portfolio, then you should spend more time thinking about the details of your investment plan.
More simply: saving is for the poor and investing is for the rich.
Don’t take this statement too literally. I use the term poor (and rich) in both an absolute and relative sense. For example, as a recent college graduate partying in San Francisco, I definitely wasn’t poor on absolute terms, but I was poor relative to my future self.
Using this frame of mind, it is much easier to see why saving is for the poor and investing is for the rich.
If I had known this at age 23, I would have spent more time developing my career and growing my income instead of questioning my investment decisions. Once I had a bigger nest egg, then I could have fine-tuned my portfolio.
How do you know where you are on what I call the Save-Invest continuum? Use this simple calculation as a guide.
First, figure out how much you expect to comfortably save in the next year. I say “comfortably” because this should be something that you can achieve with ease. We will call this your expected savings. For example, if you expect to save $1,000 a month, your expected savings should be $12,000 a year.
Next, determine how much you expect your investments to grow in the next year (in dollar terms). For example, if you have $10,000 in investable assets and you expect them to grow by 10%, that means you are expecting $1,000 in investment growth. We will call this your expected investment growth.
Finally, compare the two numbers. Which is higher, your expected savings or your expected investment growth?
If your expected savings are higher, then you need to focus more on saving money and adding to your investments. However, if your expected investment growth is higher, then spend more time thinking about how to invest what you already have. If the numbers are close to each other, then you should spend time on both.
Regardless of where you currently are in your financial journey, your focus should shift from your savings to your investments as you age. To demonstrate this, consider someone who works for 40 years while saving $10,000 a year and earning a 5% annual return.
After one year, they will have invested $10,000 and have earned a $500 return on this investment. At this point their annual change in wealth from savings ($10,000) is 20 times greater than their annual change in wealth from investing ($500).
Now fast forward 30 years. At this point they will have $623,227 in total wealth and will earn $31,161 from this sum in the next year (at the same 5% annual return). Now their annual change in wealth from savings ($10,000) is three times less than their annual change in wealth from investing ($31,161).
You can visualize this transition in the following plot, which shows their annual change in wealth broken out by type.
As you can see, in the first few decades of working, most of their annual change in wealth is being generated by their yearly savings (the darker gray bar). However, in their final few decades, it is their investments (the lighter gray bar) that contribute far more to their yearly growth.
This shift is so pronounced that, by the end of their working life, nearly 70% of their total wealth has come from investment gains, not annual contributions!
This is why the Save-Invest continuum is so important for determining where your financial attention will get its best return today.
At the extremes, it’s obvious. If you have no investable assets, then you need to focus on saving. And if you are retired and can no longer work, you should spend more time on your investments.
For everyone else, the question of where to spend your time is a bit harder. This is why there are two parts to this book. The first is about saving (the first stage of the Save-Invest continuum) and the second part is about investing (the second stage on the continuum).
To start things off, let’s look at the right way to think about saving.