Should I save or invest my money? This is one of the questions I wish I heard a lot more often from friends and family.
Let me illustrate why this crucial question can single-handedly decide how secure and comfortable your financial future is going to be.
We started our Financial Independence (FI) journey in earnest only around two years ago – January 2017 to be exact. I stumbled upon the concept of FIRE, dove into it and Mrs. CED quickly came on board.
But that’s not the first time I had thought about the idea of financial independence. No, that first spark of enlightenment occurred well before that.
My wife and I have always been diligent savers, having grown up in families where saving was emphasized overspending. So saving money and being thrifty came naturally to us. It’s not that we had a lot to save, but we made sure we saved something every month.
One day I randomly decided to calculate how much money we needed to have in fixed deposits to enough interest per month to cover our expenses.
Hold on, why fixed deposits? And how did a financially illiterate person like me even think about doing such a thing?
It’s not uncommon for Indian parents to suggest saving money in Fixed Deposits (FD) and that’s exactly what my dad recommended I do. This is largely because FDs in India still offer attractive headline interest rates like 7-9%. Of course, there are two main issues with FDs: inflation and taxation.
- India is a rapidly growing economy and has high inflation of around 4-6% annually. But the concept of getting a real rate of return over and above inflation is alien to most people, as it was to me back then. That’s why a headline rate of 7-9% sounds so attractive. I must admit that it is a very good risk-free rate of return though. But it won’t make you wealthy.
- The interest from FDs are taxed as income every year, which limits the power of compounding interest.
My father is a great investor, but more of a trader than someone investing long term for retirement. He made his wealth largely through being a very high earner and real estate bets.
So back to my story. I started calculating how much I could save and how many years I would need to reach a point where work becomes optional. I didn’t even know the term financial independence back then.
Alas, I was very disappointed to see that it would take a few decades for the interest generated by my savings to equal our expenses. Why? Because I was thinking of saving, not investing. See what I came up with:
As you can see, it looked like I could never retire early. It would take me 42 years of saving $10,000 per year. I would be 72 years old before that bank account balance of $420,000 to cover my $30,000 a year expenses (assuming I stuck it in a fixed deposit account giving 7% interest).
I had no means of saving any more with my income at the time, so this looked like a dead end.
But I am glad I didn’t pursue this plan because there were several fatal flaws in my thinking – which we will explore at the end of this post.
Regretfully, I dropped the idea of chasing financial independence at that point. If I had persisted, I would probably have been a lot closer to FI than I am now thanks to the power of compounding returns. That’s why it’s so important to start early!
Saving vs. Investing
Instead of telling you that one is better than the other based on anecdotal evidence, I am going to prove it using numbers. We will look at three scenarios, 1 for saving and 2 for investing:
- Save the money (stick it in a bank savings account)
- Invest savings to protect against inflation (invest in inflation-protected bonds)
- Invest savings to outpace inflation (invest in equities)
So that the examples I use are consistent across this blog, I will use the same age, spending and saving assumptions as in our Ultimate Beginner’s Guide to FIRE post.
Let’s assume you are 30 years old. Your annual net household income is $60,000, and current annual household expenses are $30,000. So your family can save $30,000 a year.
Let’s say your desired withdrawal amount in early retirement is also $30,000 (for the sake of simplicity).
You are quite cautious, so you want to withdraw no more than 3% from your portfolio. So your required portfolio of invested assets at the time of early retirement is 30,000/3% = $1 million.
This money is in today’s terms. In FIRE math, we always bring back currency figures to the value of money today so that we can relate to it. We know what $1 million can get you today, but thanks to inflation that $1 million is going to get you a lot less stuff in say 30 years time.
So we use the present value of your future FIRE portfolio because it’s easier to understand and relate to. Plus it makes the math a lot easier to follow.
Scenario 1 – Saving in a low-interest bank savings account (Negative real rate of returns)
Suppose you are going to just save the $30,000 annually in a bank savings account that gives you 1% interest. Might sound crazy to some but this scenario is not at all uncommon. Around 40% of Americans do not invest their savings at all, they only save what they can in a bank savings account.
Here’s the average bank savings account interest rate across the developed world in 2019:
So my assumption of 1% interest rate is actually quite liberal.
Let’s assume the average rate of inflation is 3%. So your real rate of return is 1% – 3% = -2%. In other words, your savings are growing at less than inflation. The purchasing power of your portfolio is actually reducing, and you are losing money in real terms.
Here’s a graph that shows what would happen to your savings in this scenario:
So you would be 86 years old when your retirement portfolio hits the target of $1 million. But you actually would have to save up $1.7 million to do that! Why?
Because the loss of returns due to inflation (-3% every year) compounds every year. You will end up losing $700,000 of your nominal gains to inflation over that time period. Yes, this is the power of compound interest working in reverse – the power of inflation compounding against your portfolio and eating away at it every year!You have to get a positive real rate of return on your investments! Click To Tweet
Takeaway: This scenario shows why you should aim to get a rate of return above inflation on your investments. Not just if you want to FIRE, but for any investment to make sense.
Scenario 2 – Keep pace with inflation (Real rate of return of 0%)
Now in this scenario, you have wizened up and realized that you need to beat inflation. But you do not trust the equities markets and have a significant fear of losing your money. You want a guaranteed return on your savings that beats inflation.
Your research leads you to inflation protected investments such as:
- Treasury Inflation-Protected Security (TIPS) bonds in the USA, or
- Inflation‑Linked Bonds (ILBs) in the UK, or
- Inflation-linked Government Securities from European governments, or
- the Reserve Bank of India’s (RBI) Inflation Indexed National Savings Securities-Cumulative (IINSS-C) bonds
Here’s a graph that shows what would happen to your money if you saved and invested it in this scenario:
The first point to note is that you would now reach your $1 million portfolio target by age 63! That’s just 33 years of saving and investing vs. the 56 years in scenario 1 where you stuck with a bank account!
But lets take a deeper look. The nominal growth of the portfolio looks impressive with a 53% cumulative return. But after inflation has its way with the portfolio each year, your money doesn’t grow in real terms at all.
Another way of looking at it is that it takes 33 years to get to the $1 million because you have to save $30,000 for 33 years. 33 x $30,000 = $1,000,000With a real rate of return of 0%, you have to save 1 year's worth of expenses for every year of retirement. Click To Tweet
Takeaway: So with a real rate of return of 0%, you have to save 1 year’s worth of expenses for every year of retirement.
If you keep you $1,000,000 portfolio invested in the same inflation protected bonds, you are going to run out of money in exactly 33 years again!
Scenario 3 – Outpace inflation with equities (Real rate of return of 5%)
Now we’re talking! Let’s assume you are going to save your $30,000 a year and invest it in an index fund like the Vanguard Total Stock Market Index Fund (VTSAX) or the iShares Core MSCI World UCITS ETF (EUNL:XETRA).
Let’s assume a total rate of return of 8% and inflation still at 3%. So the real rate of return is 8% – 3% = 5%.
Here’s a graph that shows what would happen to your money if you saved and invested it in this scenario:
Wow, just look at that. Starting from absolutely ZERO savings at age 30, you would be financially independent with a portfolio of $1 million at the age of 49. That’s $0 to $1 million in just 19 years!
What’s more, remain invested after retiring early and in all probability your portfolio will keep growing even after you withdraw your chosen 3% every year (adjusted for inflation so that your lifestyle doesn’t suffer).You need to get a positive real rate of return that's well above inflation both in the accumulation stage and in the withdrawal stage of FIRE. Click To Tweet
Takeaway: You need to get a positive real rate of return that’s well above inflation both in the accumulation stage and in the withdrawal stage of FIRE.
Should I Save or Invest?
Let’s summarize the three scenarios we analysed:
- Save the money (stick it in a bank savings account) – Become financially independent at age 86
- Invest savings to protect against inflation – Become financially independent at age 63
- Invest savings to outpace inflation and grow in real terms – Become financially independent at age 49
The answer that screams out from the analysis is – you should invest, not just save! Wouldn’t you like to save & invest for 19 years and then never have to work for money again? That’s financial independence!
Moreover, invest to get a high positive real rate of return. This is possible by investing more in equities (stocks) than in fixed-income assets such as bonds.The answer just screams out at you from the analysis - you should invest, not just save! Click To Tweet
Where and how should I invest my savings?
The first step is to build up an emergency fund of 6-9 months worth of expenses. This will protect you if you suddenly lose your job or are unable to work.
If you are brand new to investing, check out our beginner’s guide which will teach you all about the different ways to invest.
Did you figure out the fatal flaws in my first FIRE calculation?
Firstly, I didn’t know about investing. I thought investing meant buying and selling individual company stocks for profit – that’s trading by the way. The only way I knew to create wealth was to earn it and save it in a bank account.
A lot of young people usually do this to save up for a deposit on their first house. Hey we did it too!
But the right way is to invest your savings that are meant for long term goals – such as a house purchase in 7 years time or for retirement (early or not).
So you need to invest your savings in the accumulation stage of Financial Independence.
Secondly, after accumulating your target retirement portfolio (in just 19 years from scenario 3 above), you need to keep the portfolio invested! Don’t stick it in a fixed deposit giving a low or negative real rate of return as I was imagining I should.
Even traditional retirement experts will tell you that you have to keep a significant portion of your portfolio invested in equities during retirement. This is so that you get a real rate of return and so you don’t run out of money before you die.
For early retirement aspirants, this is doubly important. You have a longer retirement period, even up to 60-70 years ahead of you. You have to be invested heavily in equities or increase your portfolio size accordingly so that you don’t have to look for work in old-age.
Did this post help you? Did you have a eureka moment when you realized you need to invest, not just save? Leave a comment below!