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Savings vs Returns

Have you ever day-dreamed about striking it rich? Be honest. Really, what’s not to love about a get-rich-quick scheme, where you plunk down a small amount of money and watch it magically transform into a pot of gold? Lotteries and Las Vegas have made that very dream a booming business.

Wall Street offers similarly alluring opportunities.

Take, for example. If you would have invested $10,000 in Amazon when it first traded publicly back in 1997, you would have just shy of $5 million today.

Amazon’s success occurred in plain sight. So why didn’t we all take advantage of that opportunity? It was obvious the company would inevitably become a business juggernaut, right? Not so fast.

Finding Amazon – or the next Amazon – is incredibly difficult. A recent study by a finance professor at Arizona State University explains why. Of all the stocks that traded on major U.S. stock exchanges from 1926 to 2016, only about 4% accounted for all the net investment gains in the U.S. stock market. The other 96%? They collectively matched the returns of a one-month Treasury bill, a pathetically low return.

Predicting Amazon’s ascent from online book-seller to retailing goliath was no easy feat. But for argument’s sake, let’s say you were able to identify Amazon’s potential back in 1997. The next question is could you have maintained your conviction about Amazon’s success throughout the years? For instance, between 1999 and 2001, Amazon’s stock price fell by an astounding 95%! Or think about the 199 occasions when Amazon’s stock dropped by 6% or more in a single day. Amazon’s road to 49,000% returns over those 20 years was at times a gut-wrenching ride.

It is not only intellectually, but emotionally difficult to be an investing genius. And that brings us to the central question of this memo: Do you have to be an investing genius to prepare for a successful retirement? Fortunately, the simple answer is ‘no.’ In fact, you would do well to focus more on the amount you save rather than the return on those savings. Why? Read on, dear reader.

The nearby chart tells a simple story of two friends, Sue and Tim. They both earn $60,000 per year. Sue is a good saver and contributes 15% of her compensation to a 401(k) plan, investing in a low-cost and broadly diversified index fund that generates 8% annual returns over 30 years.

Tim, on the other hand, enjoys spending money and contributes only 5% of his paycheck to a 401(k) plan. Fortunately for Tim, however, he happens to be an investing genius. His magic touch for picking winning investments nets him an annual return of 12% – an incredible accomplishment for even superstar investors over a 30-year period.

The last row of the chart provides the punch line. Despite earning four percentage points less in returns each year, Sue, the saver, has almost $300,000 more in retirement savings than Tim.

That’s not to say investing is irrelevant. It’s not. Being properly diversified and having the right mix of stocks, bonds, and cash make a big difference over time. But you must first have cash available to invest, which means you must first focus on saving.

Very few of us will ever win the lottery or hit it big in Vegas. We may never find the next Amazon. And that’s just fine. Being a good saver may be enough. Leave those more exciting pursuits where they belong – in your dreams.

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