When saving for retirement, there are three big factors that have an impact on the final outcome: how much you save, what return you get on your investments, and how long that growth has to compound.
Many investors tend to focus mainly on the second of those. They spend a lot of time worrying about how their portfolio and its underlying funds are performing.
This can become such an obsession for some that it may even cause them to make the mistake of chasing performance and trying to pick the best funds year after year. They move their money between funds regularly trying to capture the best returns.
The major problem with this thinking is that performance is the one factor that an investor actually cannot control. Of course you can make sound decisions about which funds you use and therefore give yourself the best chance of seeing good returns, but nobody can predict the markets.
No investor, or financial advisor or fund manager for that matter, can make any decision that they will be certain will guarantee them an extra 1% return over the next year (unless it is switching from one bank deposit to another). There is simply no way of knowing what markets will do.
That is why investors should rather spend more time considering the factors that they really can control.
The first of those is how soon you start. There are thousands of articles all over the internet explaining why it is so important to begin investing for your retirement as early as possible, because the more time you have the greater the power of compounding becomes.
A simple example makes this clear. Assuming an annual growth rate of 10%, an investor who saves R1 000 every month from the age of 20, would have accumulated more than two and a half times as much money by the age of 65 as someone who saves the same R1 000 every month but only starts at age 30.
This is despite only actually contributing 28.6% more. The major difference is time.
|Investor A||Investor B|
|Monthly contribution||R1 000||R1 000|
|Starts at age||20||30|
|Years to retirement||45||35|
|Total contributions||R540 000||R420 000|
|Assumed annual growth||10.00%||10.00%|
|End balance||R10 569 855.89||R3 828 276.70|
The other factor within an investors control is how much they save. And what most people don’t realise is that this actually has a bigger impact than the return they are able to achieve.
Simply put, every extra 1% you are able to save is worth more than an extra 1% return.
To illustrate this, consider an investor saving R2 000 per month. A 10% return over the year would mean they would have R2 200 at the end of it.
If they saved an extra 1%, which is R2 020 and earned the same 10% return, at the end of the year they would have R2 222. If however they saved the same R2 000 and earned an 11% return, they would have R2 220.
That difference may seem very small, but as the table below shows, it does have an effect over time.
|R2 000 per month||R2 020 per month|
|11% return||10% return|
|After 5 years||R154 343.48||R155 886.91|
|After 10 years||R402 915.20||R406 944.35|
|After 15 years||R803 242.44||R811 274.86|
|After 20 years||R1 447 973.46||R1 462 453.19|
Earlier this year National Treasury announced that the annual contribution limit on tax-free savings accounts would be increased from R30 000 to R33 000. That is 10% more. If every investor made that additional contribution (which is only R250 per month), they would be making a very big difference to their final outcome.
The significant thing for investors to appreciate is that the factors that lie within their control have a major impact on their wealth. Instead of spending time worrying about finding a fund that could give an extra 1% a year performance, they would achieve more simply by saving a few extra rand every month.
Focusing on the things you can control also means you will be less likely to make emotional decisions about switching investments and chasing performance. Rather understand where you can really make a difference, and do those things instead.
Source: Moneyweb, Author: Patrick Cairns