If you don't save, you can't invest. It's that simple. The 600 investors who responded to our 2002 "What Works" survey were nearly unanimous-and surprisingly forceful-in their opinion that saving is the single most important key to investment success. "This is vitally important: saving today so you can have financial success tomorrow," wrote a middle-aged investor now living overseas. "Be consistent when it comes to saving. Don't touch savings. You don't need to have three TVs, two VCRs. Make do with one of each. A good investor has to find happiness with what's around him. You don't need to purchase material things to be happy."
The simple act of regularly setting aside money outweighs the importance of asset allocation, investment selection, tax management, and every other element of investing. Selecting an appropriate mix of stock and bond funds and cash investments, keeping a lid on costs-certainly, these things are important, and the larger your portfolio grows, the more important they become. But first you need to grapple with the reality articulated by a midcareer executive near Chicago: "You can't invest and grow money that you don't have. There is no better way to build wealth than saving."
A good savings program also compensates for the inevitable mistakes that all investors make. We heard from investors who lost every dime they invested in limited partnerships, risky initial public offerings (IPOs), and oddball tax shelters, often destroying big chunks of their net worth. If regular saving is a habit, however, these mistakes rarely prove fatal.
Saving can provide some emotional benefits, too. Results from the "What Works" survey and from academic research indicate that those who began saving early, as well as those who made it a habit, reported less anxiety about future financial uncertainties: health care costs, retirement income, and stock market declines. Many also got a sense of satisfaction and accomplishment from saving.
Saving is the foundation on which every other investment lesson in this book rests. In this chapter, "What Works" investors recount their efforts to make saving a high priority, including their attitudes toward a practice that, in essence, means forgoing today's wants for tomorrow's needs. The findings of a recent academic study about the role of savings in building wealth are also discussed. This research emphatically corroborates the observations of the "What Works" investors. At the chapter's end, the investors suggest simple steps you can follow to enhance your own savings.
Everyone Can Save More
There are thousands of reasons not to save. Most people are familiar with the general dilemma (if not all the specifics) described by one investor. "At 20 years of age, it's 45 years to retirement, an eternity. Plus there is no way to really know how much you should be saving, because you have no way of knowing how much your investments will earn in 45 years, what the rate of inflation will be, what your lifestyle will be in retirement, and how much you will need to finance it. Then there is competition for your income-family, marriage, divorce, remarriage." There's just not much left to save, and every year there's less, as illustrated by the collective actions of the nation's savers and spenders in Figure 1.1.
That's the conventional wisdom, at least. But some "What Works" investors learned a different lesson in their unconventional reality. One Texas investor said his greatest investment experience was "watching my mother save money living on Social Security while seeing a N.Y.C. lawyer friend barely make ends meet on $500K in annual salary. 'Spend less than you earn and invest the rest' is true regardless of the number of zeros in your paycheck." In fact, academic research has shown that people of just about any income level have the means to save their way to impressive levels of wealth. Saving no doubt requires some changes in consumption and behavior, but the notion that most people earn just enough to get by isn't supported by the data.
Steven F. Venti, an economics professor at Dartmouth College, and David A. Wise, a Harvard University economist, recently studied the differences in wealth accumulation for close to 4,000 households with similar lifetime incomes. Even among workers who took home similarsized paychecks, there were big differences in the amount of wealth accumulated.
Many of those with the lowest lifetime incomes-meaning the sum total of their lifetime paychecks placed them in the bottom 10% of all earners-finished their working lives with zero wealth. Not surprising. However, about 10% of those low earners accumulated an average of almost $200,000, and a small handful boasted more than $500,000 in wealth.
At the other end of the wage scale, the professors found a number of high earners with very little to show for years of big paychecks. About 10% of these high-income households finished their working years with less than $200,000, though the richest 10% amassed millions of dollars in wealth.
The primary reason for these differences in wealth is simple: saving. Those who saved the most accumulated the most wealth, while those who saved the least wound up with very little. Other factors had minimal bearing on the amount of wealth accumulated. An inheritance from a rich aunt, a costly medical crisis, or even whether a household had children made a relatively small impact on the amount of wealth acquired over a working lifetime.
Neither, surprisingly, did the way those savings were invested. A household's exposure to higher-risk, higher-returning assets such as stocks didn't explain much of the differences in wealth. Venti and Wise concluded that most of the difference between the wealth of those with similar incomes "must be attributed to differences in the amount that households choose to save."
Our survey found that 16% of high-net-worth investors (with Vanguard assets of at least $250,000) who were still in the workforce had household incomes of less than $100,000 a year. That threshold allows for a nice income, but it's by no means a king's ransom. Modest income and immodest wealth don't need to be a contradiction in terms. "It doesn't matter how much you make," a California retiree told us, "it's how much you save."
A Little Goes a Long Way
You don't have to start big, but it helps to start early. "A lot of people just think, 'Oh, I'll do it later,'" a "What Works" respondent told us. "I remember a quote from [famous investor Warren] Buffett that said something like 'the best savings is early savings.'" The earlier you start, the better your ability to harness the awesome power of compounding-the process by which your savings earn interest, and by which that interest earns interest, and that interest earns interest, and so on. One mark of the unsuccessful investor is "spending too much when you are young, so you don't accumulate enough wealth to invest when compounding would do the most good," observed one respondent. As the saying goes, it's not timing the market, it's time in the market.
Suppose you start saving $100 a month at age 25. You invest the money in a mix of stock and bond funds that returns an average of 8% a year. The results are presented in Figure 1.2. By age 40, after 15 years of investing, your total contributions of $18,100 have increased in value to $35,167. Not bad, but not life-changing money, either.
From that point on, however, compounding kicks into high gear. The account's 15 years of accumulated interest now represent a large enough pool of assets that earnings on your earnings become real money. The darker mountain chart in Figure 1.2 slopes sharply upward, while the amount of money contributed-the relatively flat slope at the foot of the mountain-continues to creep up at just $100 a month.
After another 15 years, the value of the account has grown to $151,130, while your contributions total just $36,100. And at the end of 40 years, when you reach age 65, the account is worth $351,528-more than seven times your lifetime contributions of $48,000. The mathematical abstraction of compounding provides concrete benefits in the real world. "Get into a regular investment program when you are young," a Midwest investor told us. "The difference in cost between an Accord and a BMW will buy you several nice cars if invested wisely until retirement."
Becoming a Saver
Saving comes easier to some people than to others. Some people we spoke to developed the savings habit in youth, were inspired by a family member, or were shaped by the unique circumstances of their time and place. Others seemed to be natural-born savers, instinctively husbanding resources for the future.
"I was born in 1926, and I remember when the banks closed," one West Coast investor told us. "In the school system, Bank of America had some kind of savings program for kids. I had a small bank account. During the Depression my father was a salesman, and an axle broke on his car, and he took the money out of my account. So it all started with school." During World War II, this investor earned $50 a month in the U.S. Navy, and used $18.75 of it to buy War Bonds. Saving 38% of your income sounds extraordinary today, but people of the same generation told us similar stories. "Saving is a virtue for people of the Depression," another respondent said. "We tried to teach our children to spend wisely. That was different for me. I was taught to save and hang on to it."
Some people were inspired by the example of a family member or the counsel of a public figure. A city worker, now retired, told us, "There are various things in your life that make a life-changing impact. Earl Nightingale was a motivational speaker back in the 1950s and 1960s. He said '10% of what you earn is yours to keep.' Since then, we've always tried to save 10% and give 10% to the church or charities."
This investor's father-in-law was another important influence. "He invested in stocks and bonds every month from the 1950s until his death in 1996. He was just a floor supervisor at Ford Motor Company. He had a modest income, but he was able to leave $1.9 million in his estate."
Sometimes the savings impulse represents a combination of instinct and conscious effort. "In the 1950s, I would mow lawns around the neighborhood. And I would be paid in coins. I would put them in a can and melt candle wax on them, so if I wanted to get at the money, I'd have to boil the coins. It was forced saving." These savers owe some of their success to chance: the good luck of being born into a family that set a good example, or the paradoxical luck of coming of age during a tough time in the nation's history. But what if you grew up in easier times? Or never learned much about saving from your family or other role models? There are a number of time-tested methods for increasing your savings. You might need to kick some old habits and adopt new ones, but these strategies work precisely because they're not terribly painful. The first step is coming to terms with the anti-savings: debt.
Dealing with Debt
Debt isn't necessarily bad, but "do not borrow money for anything that does not appreciate in value (education and home)," one investor cautioned. Debt incurred to pay for education should translate into higher earnings, more than compensating for the cost of the loans. Mortgage loans are another big source of borrowing. Few homebuyers can pay cash, but you need a place to live, and as you pay down the loan, you build up equity, a kind of savings, in your home. Plus, home values have tended to appreciate, and Uncle Sam helps you pay the mortgage by allowing you to deduct the interest on your loan from your income for tax purposes.
The most dangerous kind of debt is high-cost revolving, or credit-card, debt. "Pay off all credit cards now!" thundered one "What Works" investor. In 2001, revolving debt approached $700 billion, analogous to a credit-card balance of some $2,500 for every man, woman, and child in the United States. Personal bankruptcies skyrocketed, as debt overwhelmed a record 1.4 million people. Credit-card debt is often incurred to pay for fleeting pleasures or the doodads and gizmos that wind up at the bottom of your closet.
Suppose you borrow $1,000 to buy a digital gizmo. Your credit card charges an annual interest rate of 18%. You make payments of about $30 every month. Four years later, your purchase is paid in full-only it doesn't work anymore. It's sitting at the bottom of a landfill. And the $1,000 you borrowed has wound up costing you $1,400, including financing charges. In economic terms, your costs are even higher. You've lost the opportunity to earn a positive return on that $1,400.
One respondent told us that he thinks of debt as a negative investment. Success is a question of getting on the right side of debt's cash flows. "My grandfather taught me that rather than paying interest to someone else, you should be on the receiving end of interest. I want to be the one who receives the dividends and interest," he said. "My grandfather lent money to people during the Depression and lived on the interest. I've always paid cash for everything, so I've paid very little interest to other people."
Psychological Benefits of Saving
The rewards of a good savings program are more than monetary. "What Works" investors reported that saving provides psychological and emotional benefits, too. More than one-third voiced strong agreement with the statement, "I get a lot of satisfaction from saving for the future." A larger proportion of the high-net-worth investors agreed strongly.
Saving serves primarily to help you meet future material needs, but it can be imbued with emotional value, too, either positive or negative. "My grandparents gave me some money about the time I started high school, and at their suggestion, I put it in a money market account. By graduate school, it was there to help finance costs my stipend wouldn't cover. Also, there were times when it gave me a lot of comfort to know that I'd managed to preserve those gifts, and that I had them for a rainy day."
The "What Works" survey indicated that those who committed themselves
to a savings or investment program early in life felt more confident
about the future. Table 1.1 shows the percentages of "early savers"
and "later savers" who agreed strongly with five statements related to
the emotional and psychological aspects of saving and investing. On average,
early savers had a more positive outlook. Not saving can force
you into stressful financial-and emotional-situations. "The average
person saves so little that they feel forced into high-risk investments and
lottery tickets. They have a need for instant gratification: a 54-inch TV,
ocean cruise, fancy new car, two cell phones, and a partridge in a pear
tree," said one respondent.
Excerpted from Wealth of Experience by The Vanguard Group Copyright © 2003 by The Vanguard Group. Excerpted by permission.
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