Investing Principle 3: The Top Success Factor

by Mark W. Riepe, CFA, Senior Vice President, Schwab Center for Financial Research
May 20, 2008

The fourth article in an 11-part series on Schwab's investing principles.

Let's explore the thinking behind Schwab's Investing Principle No. 3: Saving and spending rates have the greatest impact on success.

I suspect that any experienced investor would testify that investing is quite humbling. There are so many uncertainties at play when we make decisions about what to buy and sell. Even the best investors get it wrong surprisingly often.

To combat this, investors should never lose sight of those aspects of investing that they can control. For example, no one controls what the stock market does. It may go up and it may go down. Investors have opinions as to what may happen, just like we have opinions about the future direction of the stocks and mutual funds we own, and those opinions may be well founded and correct most of the time—but that's not the same thing as control.

The good news is that the most important factor in achieving your financial goals also happens to be the one thing over which we exert the most control. And that's how much we choose to save, or conversely, how much we choose to spend.

3 important steps	10 proven principles
Create a plan	1. Having an investment plan that is realistic and actionable is crucial to meeting goals. 2. Understand your plan, follow it and adjust it when things change in your life.
Put it into action	3. Saving and spending rates have the greatest impact on success. 4. Diversification is the second-most important factor in reaching goals. 5. Select the asset allocation that’s right for you and stick with it. 6. Choosing professionally managed investments can be a better way to invest. 7. Acting now generally beats waiting.
Stay on track	8. Periodic checkups keep a portfolio healthy. 9. Progress toward goals is more important than short-term performance. 10. Use the right benchmarks to evaluate performance.

The power of savings
As I considered Schwab's third investing principle, I thought about one of my daughters who is in third grade and involved with gymnastics and piano lessons in addition to her regular school work. Not surprisingly, she sometimes gets frustrated with how she's progressing. I always remind her that in most situations the best thing she can do is just practice a little bit more on whatever it is that's giving her fits. Whether it's multiplication tables, or that new song the piano teacher just introduced, or better form on the balance beam, extra practice solves a remarkable variety of problems.

The power of saving is just like the power of practice. It doesn't sound like the most sophisticated advice, but it's remarkably effective.

Let me give you an example: Let's assume you expect to retire 25 years from now. If you save $125 per paycheck and are able to invest that money and earn a 9.4% rate of return, you will have nearly $300,000 at the end of the 25 years. If you doubled your rate of savings to $250 per paycheck you'd have nearly $600,000 instead. That's a far more formidable nest egg on which to rely during your golden years.

Risk and return
You might be thinking that my example sounds nice, but you're more interested in learning how you can get to that $600,000 level while still maintaining your savings rate at $125 per paycheck. In other words, you're hoping to make up the difference by investing smarter—you want to find the right combination of stocks, mutual funds and bonds that will allow you to earn a higher rate of return while avoiding the short-term difficulties involved with boosting your savings rate.

That's a reasonable question. One way to boost your expected return is to increase the level of risk you're taking with your investment portfolio (I'll be talking about this very point later in the series). But never forget that there's no free lunch when it comes to risk-taking. If you need a real-world example, just think about how the stock market has been so up and down in the latter part of 2007 and the early part of 2008.

You should think through a decision to increase portfolio risk very carefully. It may well be the right decision depending on your situation, but be prepared for the consequences associated with that path before taking the plunge.

Saving trumps skill
What about earning a higher return without taking on more risk? Well, that's the nirvana of investing and many professionals in the investing world devote their lives trying to achieve exactly that.

Success, however, doesn't come easy—if it comes at all. In the earlier example, if you wanted to boost your wealth at the end of the 25 years from $300,000 to $600,000 without taking on more risk, you'd need to increase your annual rate of return by over 4 percentage points—and you'd need to keep that up for the full 25 years.

Virtually no one has been able to generate that kind of track record. I believe that there are bargains in the financial marketplace, but I'm also convinced that there aren't enough of them lying around to make up that kind of shortfall.

In other words, it is possible to be a successful investor and beat market averages, but it's unlikely that you'll be skillful (or lucky) enough to pick stocks and mutual funds that, by their performance alone, generate the wealth you need to achieve your long-term goals. You need to do your part through savings—just like professional musicians wouldn't get to where they're at without practice, practice and more practice.

Already retired?
If you're retired and living off a portfolio that has more fixed income investments, there are opportunities to increase the yield from your savings, but again, those opportunities almost always come with extra risk attached. And so you need to keep a handle on your rate of spending. That's the strongest lever you can pull, and the good news is that it's well within your grasp.