In 2013 the market and those invested in it experienced a nice return on their investments. The S&P 500 rose an amazing 29.6% while the Dow rose 26.5%. Needless to say 2013 was an amazing year for investors – but try not to make the following mistake:
Don’t confuse investment returns with savings.
While it is true that the more of a return an investor receives on his or her investments the less they have to save it still does not mean that your returns should take the place of systematic saving for retirement, college or the proverbial rainy day. And by no means should you reduce the amount you’re saving thinking that the returns from 2013 and other bull years will repeat and continue their upward bounty.
Investment returns are the returns that an investor receives in a particular time frame. For 2013, if an investor was invested in the S&P 500 or an S&P 500 index fund they received almost 30% returns for the year. Not bad. But this is deceiving. Not to burst anyone’s bubble, but we are only looking at one year. If an investor was saving for retirement for over 30 years, to expect 30% returns each year for 30 years is like expecting my chickens to lay golden eggs – it ain’t gonna happen!
But what if an investor stops systematically saving, thinking that a 30% increase in their portfolio for 2013 can offset any additional money they intended to put in? The result would be disastrous to their retirement plan. Perhaps some numbers can help explain.
Let’s assume that we have two investors, Alex and Neil. Both are age 30, both will retire at age 65 and both start with $10,000 in their IRAs at the beginning of 2013 and both are invested 100% in the S&P 500. At the end of 2013, both investors have $13,000 in their IRAs. Up until the end of 2013, both Alex and Neil had systematically contributed the maximum to their IRAs annually – about $5,000 annually. Now they can contribute $5,500 annually.
Alex decides that since 2013 rocked, he will not contribute to his IRA for 2014 thinking that 2013’s numbers will last forever. Neil decides to keep drumming away and putting in his annual amount ($5,500 for 2014) at a steady rhythm.
Neil is handsomely rewarded for his commitment and over the next 35 years, at a 6% average annual return he amasses close to $690,000 ($698,752 for those of you with your financial calculators).
Alex is sporadic. After up years in the market he doesn’t invest and after down years he thinks he needs to contribute. It turns out that there were 20 years of downs and 15 years of ups – so Alex invested his annual IRA maximum 20 times, instead of Neil’s 35.
Keeping the math simple, let’s say that the market was down for the next 20 years causing Alex to save and then up the last 15 years causing him to relax his savings commitment. In 20 years, since there were no gains Alex has $123,000 (we assume no losses in this down market).
In the next 15 years, Alex averages 6% return and contributes nothing since they are up years. At the end of 35 years Alex has roughly $295,000 ($294,777 for those of you still calculating) – or about $400,000 less than Neil.
Admittedly my examples are very simplistic and a bit unrealistic. But the point is to not confuse your investment returns with savings. They are not the same. An investor still needs to stick to their savings plan regardless of what the market does.
In up years and I would argue more importantly in down years you need to stick to your plan of saving regularly – along with the ups and downs to take advantage of compounding returns and buying less when the market is overpriced and more when it’s under-priced.