Focus on Saving, Not Investing

February 2, 2011
Setu Mazumdar, MD

Physicians who manage their own investments -- and financial advisors who manage investments for physicians -- overwhelmingly focus on investment return rather than the one thing that will guarantee your portfolio will increase in value: Saving. Here's why saving more now is more important than earning more later.

Even with all of the new drugs, technology, and procedures in medicine today, there are certain things beyond your control. For example, if we get myocardial infarction patients to the cath lab within 30 minutes, there will still be a certain percentage with a poor outcome. It’s something we have to accept.

But when it comes to investing, physicians don’t accept the fact that most things are beyond your control. Let’s say you have a choice of doing one of two things with your investments:

Choice A: Focus on things you can control.

Choice B: Focus on things you cannot control.

Which one would you choose? Obviously it’s choice A. The problem is that physicians who manage their own investments and financial advisors who manage investments for physicians overwhelmingly focus on Choice B.

By that I mean focusing too much on investment returns -- unfortunately, no one has control over that. Sure you can reduce risk by diversifying, but no one knows what investment returns are going to be today, tomorrow, next week, next month, or next year. And certainly not over the next 30 years.

Herein lies a great paradox of investing. While investing is aimed at generating a rate of return on a portfolio in order to increase the value of that portfolio, it’s actually far less important than the one thing that has the greatest impact on the value of your portfolio.

That one thing? The dollar amount of your annual savings. Most physicians and financial advisors gloss over this.

Let’s take an example. At the beginning of your investing career, you start with a portfolio value of exactly zero. Assume that you save $50,000 every year. (If you are making $300,000 or more every year and you are not saving at least $50,000, you’re doing something terribly wrong.)

After one year you have a $50,000 portfolio. If the market drops 20%, you’ve lost $10,000 leaving you with $40,000. But the next year you add another $50,000 so your portfolio is now $90,000. If your portfolio increases by 20% in the first year, you would have $60,000 and then after adding another $50,000 you end up with $110,000. The point is that no matter whether your portfolio has positive or negative returns, the value of the portfolio depends much more on the amount you pump into it -- your annual savings.

Even midway through your career the math still makes the savings rate rank high. For example if you have a $500,000 portfolio and the market drops 20%, you’re left with $400,000, but the next $50,000 you save brings you back up to $450,000. You’ve recovered half the loss with your next contribution.

It’s not until your portfolio reaches far higher values that investment returns take over. At $1 million, a 20% loss brings you down to $800,000 so pumping in $50,000 only brings you back up to $850,000. At $2 million, you’ve lost $400,000 leaving you with $1.6 million, so the next $50,000 of new money doesn’t have as much of an effect on your portfolio value. On the flip side even a 10% gain at those portfolio values increases your portfolio by an amount greater than what you put into it annually.

But here’s the irony. To get to those higher portfolio values (when investment returns take over) you have to build up to that level from smaller portfolio values. And since your annual savings dominate your portfolio values when your portfolio value is small, ultimately your savings is the most important determinant of the value of your investment portfolio in your investing lifetime.

This week's financial prescription: Concentrate on the amount you save each year, instead of your investment returns.