Savings Ratio

Savings Ratio

Savings Ratio is the ratio of saving with respect to income. Simple example is earning 50000 and saving 25000 means the Savings Ratio is 50%. Savings Ratio is a key parameter in control of investor. In fact it is much more of a determining factor of wealth then the Earning. One can be a high earner with low savings ratio. Alternately one can have moderate income but high savings ratio. The one with high savings ratio is more likely to build long term wealth.

Returns and Savings

Market returns are difficult to predict. Two sets of people might experience very different outcomes depending on when they start to invest. One might start to invest at a beginning of bear market and other at the beginning of bull market. It is difficult for any individual to predict the future outlook and returns. However what is in ones means is how much one can save. Higher Savings ratio works as a good defense against the difference in returns. With high savings rate your contribution becomes a key component of your final net worth as much as the returns generated.

Ideal Savings Rate

Savings rate works in two ways.  High savings rate ensures more capital participates in growth. The second way in which it helps is in anchoring lifestyle which allows for a high savings rate.

What is ideal savings rate?

General consensus on  savings is in range of  20%. However this is suited for traditional retirees who work for 30-40 years and a standard  portfolio return expectations. Definitely as a starting point this is what all savers need to aim for. However in order to be a bit conservative in their return expectations and would want flexibility of retirement dates they can aim for something higher in terms of Savings Rate in range of 30%.  In case on of goals is to retire early and be financially independent in 15-20 years then consider savings rate in range of 50%. Ironically 50% savings rate is not all that radical assuming there is less investment knowledge or risk aversion to invest in equities. If the return assumptions are real returns are close to zero and one has to approximately work for 30 years and retire for 30 years in zero real return scenario 50% savings becomes the norm

Although the above numbers are ideal numbers there are a number of practical considerations and other financial goals on the way that need attention. Nevertheless the savings ratio provide the normative goal one needs to aim for in their investment journey.

Investment of Savings

Along with savings ratio the next key is the investment vehicle or portfolio.

For the investment options the market time and timing covers the underlying approach.

Expect for the  support of expenses over short time frame  use  short-term debt investments in government bonds or corporate bonds. Long term allocation to   equity lets it grow over relatively longer periods of time generating consistent returns.

Equity Mutual Funds have historically delivered 3-4 % Real Returns. If inflation is 6%, they have delivered   9%-10% if held over 7-10 years’ time frame. Considering the long time frames of retirement Equity is ideal investment for retirement savings.

Summary

• Savings Ratio is a crucial element of early financial independence.
• A combination of high savings rate and investment in inflation beating investments provides the best odds for generating wealth and reaching ones financial goals.