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This is a guest post from Dylan Ross, a certified financial planner and owner of Swan Financial Planning, LLC, a registered investment adviser in New Jersey.
How much money must you save each year to have the equivalent of $1 million today, 30 years from now?
At first glance, this sounds like an easy enough question to answer by calculating a simple annual savings amount; however, a couple of very real variables can create an enormous range of possible answers. Two of the more influential variables are (1) how the money is invested (asset allocation) and (2) what the investments return year-to-year (timing of returns). The investor can control one of these variables, asset allocation, but the timing of returns is beyond anyoneâ€™s control.
The timing of returns is important because, although an allocation may ultimately live up to average returns, the sequence of the returns that make up the average play a greater roll than the final average will. If you are saving each year, future returns will have a greater impact on your savings because they will be on larger balances. If the more favorable returns that contribute to an average happen early on when your balances are smaller, you may end up with less than you anticipate.
If you are wondering how much impact the timing of returns can have on your savings, the table below illustrates the answer to a savings question using probabilities for success. To arrive at the savings amounts, each asset allocation was subjected to 1,000 trials wherein each yearâ€™s return was randomly generated based on the allocationâ€™s risk and reward characteristics (see Assumptions below).
Savings targets are shown at 70%, 80% and 90% probabilities for success because those are numbers that may seem reasonable to plan for. A 50% target is coin-flip odds and generally too low to plan your future on, and 100% certainty may be overboard and can lead to unnecessary sacrifices. Keep in mind that success is defined, in this case, as having at least $1 million at the end of 30 years of saving, so at 80%, there is a 20% chance of either having something less than $1 million or needing to save even more each year.
|60% Stocks/40% Bonds||$17,500/year||$19,725/year||$23,850/year|
» Inflation will be 3% per year.
» Investment fees are 0.20% per year.
» Savings will increase each year with inflation.
» Risk and return assumptions:
— Cash: 4.29% average return, 4.52% standard deviation
— 60% Stocks/40% Bonds: 9.71% average return, 12.45% standard deviation
— 100% Stocks: 12.32% % average return, 18.38% standard deviation
» Taxes were not included.
The first thing you may notice is that the more risk you take, the less youâ€™ll need to plan on saving each year. You may also notice that the lower risk, cash allocation savings amounts do not increase as drastically in order to achieve a greater probability than the higher risk, 100% stock allocation does. This is because higher risk investments have a wider range of potential outcomes that will impact your chances of reaching your investing goals. The risk is also mitigated by time. As the time horizon is shortened the gap between the 100% stock and 60% stock allocations will narrow and eventually the savings amounts for the 100% stock portfolio will be more than the 60% stock portfolio at higher probability targets.
This is not intended to promote one asset allocation over another but rather to illustrate the effect riskier investments can have on your savings, both positive and negative.
nickel’s thoughts: This is a great illustration of the risks that you take when you adopt a seemingly ‘low-risk’ investment strategy. Even after accounting for the inherent volatility of the stock market, incorporating stocks into your investment portfolio greatly increases the likelihood that you’ll be able to meet your long-term financial goals.
FYI: I invited Dylan to write this as a followup to an article by JLP of AllFinancialMatters which considered the costs of meeting your financial goals without stocks. Thanks Dylan!
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