A recent article in Financial Planning magazine by finance professor Craig L. Israelsen of Brigham Young University provides the answer to a deceptively simple question:
If you’re trying to catch up, are you better off trying to save more, or should you invest more aggressively to reach your goal faster?
The surprising answer? It depends on your age.
While saving more can be difficult if not impossible for many people, trying to capture higher investment returns by including more stocks and less bonds in your portfolio can backfire.
“Juicing a portfolio in hopes of cranking out higher returns increased the downside risk in any given year significantly,” says Israelsen. By downside risk, he means the amount of money the portfolio could lose in a given year. Keep in mind, says Israelsen, that a higher return portfolio is also a higher risk portfolio.
Best strategy at age 25
No big surprise, but the young investor, starting to save at age 25, can get away with more risk and less saving. And in fact, the research shows that at age 25, it’s far better to save 6% of salary and try to earn 10%, than save 10% and earn only 6%.
After all, in your twenties, time is on your side, and the miracle of compounding works in your favor.
Young investors do need to save something (otherwise there is nothing to compound!), but the key is to invest aggressively for long-term growth.
Best strategy at age 35
The same results hold true for an investor starting to save at age 35. To paraphrase Israelsen, the bang matters more than the buck. Higher portfolio returns, generated through an aggressive investment strategy, trump the impact of saving more dollars. So while thirty-somethings do need to get savings dollars into the pot, the most important ingredient is a long-term, stock-oriented growth strategy.
Best strategy at age 45
If you ever needed proof that at 45, you are indeed starting to age, here it is.
Trying to hit the ball out of the park with an aggressive investment strategy no longer cuts it. If you’re 45 or over, and trying to make up for lost time, you are far better off hiking your savings rate up to 10% of salary, then taking on more portfolio risk. In other words, now you are better off saving 10% and trying to make 6%, than saving 6% and trying to make 10%.
Your investment time frame until retirement is getting shorter, and therefore compounded returns play less of a role (and actual dollars contributed play more of a role) in building your portfolio balance. You have fewer years to make up for losses, so while you can still invest for growth, your strategy needs to be more moderate.
Best strategy at age 55
People who start to save for retirement at age 55 are coming really late to the party. That’s why they’re tempted to try to blow the lights out with a turbo-charged investment strategy. But Israelsen’s research says that is clearly a mistake.
“Investors who rely upon portfolio performance to do their heavy lifting will usually fall into the trap of having too much equity exposure and, therefore, too much risk,” argues Israelsen. The best way to reach their retirement goals is to “save as much income as they can” and be content with more modest growth.
Lessons for all ages
The bottom line, says Israelsen, is that “the performance of a portfolio should never be expected to make up for under-saving.” That’s a message we stress with twenty-something as well as fifty-something clients. The goal is to save 10% to 15% of salary each year, either in your 401(k) or IRA, or in a plain old brokerage account.
This new research suggests young investors can probably cut corners a little and get away with saving only 6% if they invest aggressively for long-term growth.
But once you hit your forties, it’s time to buckle down. Your investment returns become less important than the amount you save.
“If younger investors are willing to take more risk, there is a distinct payoff in the long run — and they have the crucial benefit of time on their side. But for older investors, taking on more risk exposes them to losses that they have neither the time to recoup nor the emotional stamina to endure.”