Why Your Income Matters More Than Your Portfolio Returns?
Yes, you read the title correctly. When you are starting out your investment journey, your returns don’t matter as much as you think they do.
Initially, your savings rate, not the returns you will generate will determine how quickly your networth will grow. Here is what Brian Feroldi (do follow him on Twitter) has to say about this.
Let me explain this with the help of an example. 100% returns on a portfolio of ₹1 lakh is just ₹1 lakh, while even if you get 10% returns on ₹1 crore, that would be ₹10 lakh.
Returns or Capital?
Now you might say that this is a very extreme example which I have taken. Let’s make this fair. Two friends Abu and Babu have got a job at the same company. They both are being paid ₹6 lakh annually. As they both know the benefits of investing early, they start investing in the stock markets.
But, there is a slight difference in both of their approaches. Abu thinks that he can beat the market and earn a significantly higher return, so he spends most for his free time to improve his returns. He thinks that he can better the market returns of 12% to 20% if he puts in the efforts.
Babu, on the other hand, knows that he needs to get his initial capital in place as early as possible. Babu knows that he can get a decent return of 12% from the index, so he spends most of free time in upskilling himself, which would increase his salary. Babu’s salary growth over a decade can easily be over 20% (this isn’t a lot as Babu would be among one of the top 5-10% in his domain).
As Abu is using up most of his free time in the stock market, he won’t be growing his salary at such rapid rate. His salary growth would be 10% at best.
For the sake of simplicity, let’s assume that both of them have expenses of ₹4 lakh annually, which grow at 7% annually due to inflation. Let’s run the numbers and see what do get at the end of a decade here.
At the end of a decade, with the help of his 20% returns, Abu would have a portfolio of a little more than ₹1 crore. Since he focused more on investments, his salary has grown just 2.5 times over the decade. Due to that his savings rate has grown from 33% to 48%. Let’s now look at Babu, who focused on growing his income, and managed his portfolio passively via index investing.
Babu’s portfolio is 50% more than that of Abu at the end of the decade. Let’s see what has contributed to this. Babu’s income has become 5 times in a decade. Due to such a growth in income, his savings rate has grown from 33% to 76%.
Now you might have understood the significance of Brian Feroldi’s image. Savings rate matters more than investment returns till the time you build your initial corpus. Here’s what the greatest investor has to say:
The best investment you can make, is an investment in yourself. The more you learn, the more you’ll earn.
— Warren Buffett
Increasing Savings Rate
Your savings rate is simply the percentage amount left from your income after all your expenses.
You have two ways to increase your savings rate:
- Increase income
- Cut down spending
Cutting Down Spending
The best way you can cut down your spending is to keep a track of it and fix where the leakages are. You can do this in a simple spreadsheet, or if you want everything at one place, you can use my budget guide.
Sure, you can cut down your expenses, but there is a limit upto which you can cut your expenses. If you look at income, there is literally no limit to which you can grow your income. Have a look at this tweet.
You can do great in your job, just like Babu. You can also focus on creating other income streams. Now that you are convinced that your income matters more than your investment returns, let’s have a look at some of the ways with which you can increase your income.
- Get better at your job
- Affiliate marketing
- Amazon FBA
- Creating digital products
This list is not exhaustive, but these are some of the best ways to start for beginners. Do research what interests you, pick one and focus on it.
Savings rate matters, and it matters more than the returns you can generate during the capital building phase. I hope this post would have given you some clarity on what you need to focus on during the initial capital building phase. No doubt, returns do matter — but only after you’ve built up that initial capital. So, start focusing on how you can increase your income and get that savings rate up.
Till next time.