I just got a job. Should I be saving or investing?
By Walter Updegrave, senior editor
(MONEY Magazine) — Where should someone just starting out in his career look to invest for his future? — Douglas S., Jersey Shore, New Jersey
I think it’s great that you want to invest for your future. And I’m certainly happy to get you started the right way on that front.
That’s not to say that investing, and doing it well, isn’t important. It is. You certainly don’t want to fritter away your money in lousy investments.
But when it comes to creating wealth and financial security over 30 or 40 years of your working life, I’d argue that you’re better off first turning your attention to saving as much as you can on a regular basis so that you have money to invest, and nurturing your career so you have more income from which to draw savings.
I know this may sound like heresy, especially coming from a personal finance columnist, but bear with me as I explain.
You don’t say how old you are, but just for purposes of an example, let’s assume that you’re 25, that you earn $40,000 a year and that over the course of your career you’ll average salary increases of 2% a year.
If you save 5% of your salary year in and year out over the next 40 years, you would have just under $527,000 by age 65, assuming a 7% annual return. (For simplicity’s sake, I’m ignoring taxes.)
There are several ways to increase that sum. But for whatever reason, the strategy that seems to pop into most people’s minds first goes something like, “Gee, I’ll end up with a lot more if I just find investments that earn 8% instead of 7%.”
And that’s true. A higher return will lead to more wealth. If you pump up your investment return to 8%, at age 65 you’ll have a portfolio worth roughly $674,000.
Problem is, squeezing an extra percentage point (or more) of gain out of your investment portfolio year in and year is a lot harder than most people think. In fact, I don’t think it’s something a reasonable person should count on.
Sure, it’s possible to bulk up your investment return if you’re starting from a truly subpar portfolio — say, one that consists solely of money-market funds or other very low-risk investments that don’t have much in the way of long-term growth potential.
But once you’ve put together a diversified mix of stocks and bonds that’s appropriate for someone of your age and risk tolerance, your chances of significantly boosting your return fall dramatically.
Essentially, your results are going to be determined pretty much by whatever return the financial markets deliver. Of course, that market return can vary substantially over different periods of time, depending on the level of interest rates and how the stock market fares.
According to Ibbotson, for example, in the 65 overlapping 20-year periods from 1926 to the beginning of 2010, a portfolio of 50% stocks and 50% bonds gained as much as an annualized 14.8% (1979-1998) and as little as 4.6% (1929-1948).
But, whatever the market return is for a particular mix of assets, it’s extremely difficult for you to beat it without taking on extra risk. So the point is that once you have a reasonable portfolio, you have very little control over the returns you’ll earn.
If stocks are generating returns of, say, 6% a year and bonds are returning 3%, it’s not as if you can just ratchet up your returns by picking stocks that will earn 7% and bonds that will earn 4%. If you do that, you’ll have to buy riskier stocks and bonds, which means you may get higher returns, or you might end up with even lower returns or outright losses.
All of which is to say that I think anyone who believes he can substantially increase his wealth over the course of a career by superior stock picking, timing moves in and out of different investment sectors and such is fooling himself. Your real goal as an investor should be to get as much of whatever return the financial markets generate.
So if you can’t rely primarily on investing, how can you create more wealth and financial security over the course of your working years? Well, I’d focus first on saving.
Remember that near $527,000 you would have by saving 5% of salary and earning a 7% annual investment return? Well, if you up your savings rate from 5% to 8%, you’ll end up with just under $843,000 by age 65. And if you can boost the amount you save to 10% of salary, you would have just over $1 million.
But there’s another lever you may also be able to use: your earning power. The more you earn during your working years, the more wealth you can build, assuming you continue to save diligently.
So, for example, if by working hard and deftly managing your career, you’re able to average pay increases of 2.5% a year instead of 2%, by age 65 you would have a bit over $900,000 socked away, assuming an 8% savings rate, and upwards of $1.1 million if you save at a 10% rate.
Admittedly, neither your ability to save nor the amount you earn is completely within your control. But I think most of us have much more influence over how much we save than on the size of returns we earn on our investments.
And while you certainly can’t just choose the salary you want — if that were the case, I’d double mine, pronto — there are steps you can take to increase your chances of boosting your income, such as getting more education or acquiring skills to enhance your career prospects, keeping abreast of the best opportunities available in the job market and establishing a reputation for hard work and productivity so prospective employers will consider you a top candidate for any openings.
But as I noted earlier, investing is also important, so I want to weigh in on that too. But here, I think the key isn’t to try to beat the market or engage in razzle-dazzle investment strategies that putatively lead to outsize returns.
Rather, the single most effective thing you can do is to set an investment strategy that allows you to get the most out of whatever opportunities for gains the economy and financial markets provide, without taking on more risk than you can stomach.
The first step toward doing that is coming up with the right asset allocation, or appropriate blend of stocks and bonds. For a youngster like yourself with many, many years of investing ahead of you, that mix will likely lean very heavily toward stocks, since over long periods of time they tend to provide the highest return.
Next, you want to choose investments with low costs so that you’re getting as much of the market return as possible. The simplest way to do that is to invest in broad index funds or ETFs. For example, if you invest in a total U.S. stock market index fund or ETF, you get the entire U.S. stock market in one fund.
And you can get such an investment at an annual cost of as little as 0.07% of assets, or just $7 for a $10,000 investment. (For more on the benefits of indexing, low costs and keeping it simple when investing, I suggest you read my recent interview of Jack Bogle, the man who popularized index investing.)
You can find all the stock and bond index funds you need to create a simple but effective portfolio on our MONEY 70 list of recommended funds. Finally, once you’ve created an appropriate portfolio and stocked it with low-cost funds, don’t undermine yourself by constantly trading and moving your money around.
Aside from occasionally rebalancing your portfolio, you should pretty much stick with whatever mix of stocks and bonds you’ve decided is right for your situation.
The bottom line, though, is that if you really want to be serious about creating a secure financial future, do all you can to earn to your full potential and regularly put away a substantial portion of your salary. Because if you don’t do that, even the smartest investing moves in the world ultimately won’t be much help.