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Why Hardcore Saving is much more Powerful than Masterful Investing

“Hmm. In this case, Mr. Money Mustache has outdone me.”

I was recently enjoying a conversation with a new friend. Despite my best efforts to sound normal and busy, this person eventually figured out that my wife and I don’t actually do enough paid work to sustain the normal middle-class life we seem to lead. From here he pried out the fact that I am Mr. Money Mustache, the freaky magician who retired at 30. When people learn this, they immediately start grilling me on my presumably amazing investment skills. You have to be a stock market wizard to retire unusually early, don’t you?

Unfortunately, I have a pretty poor investment record myself: as an early twentysomething I thought I could pick winning stocks, and ended up buying some that went to nearly zero. These were balanced by some that went up nicely, and these experiences combined to average out to about the same return the stock market as a whole would have given if I had just bought a nice index fund. Through my later 20s and 30s, I thought I was wise by squirreling lots of money away in the excellent Vanguard 500 (VFINX) index fund. But then Great Recession happened and (temporarily) backed out all those gains. I did make some reasonable money from home ownership and managing a rental house, but most of that was earned by increasing the value of the houses with old-fashioned sweat equity: renovations I did myself. In investments, you will win and lose on average, and statistically the best you should expect is to match the market (historically about 7-8% annually after inflation is subtracted out).

But let’s hypothetically say you were a masterful investor. The best investor in modern history, Warren Buffett, has averaged investment returns of about 20% per year for over 40 years. This is about 4 times higher than the laziest investor who just bought guaranteed-return bonds.

Now let’s say you are a masterful middle-income saver: you are married and you and your spouse earn $120,000 combined per year – say $90,000 after tax. With skill, the two of you can save at least $50,000 per year of your combined income between regular and retirement accounts.

Next, compare this with the average personal savings rate in the US:
– 6% right now (which is actually higher than usual because we are in a recession),
– as low as 1% during the big credit and spending boom of the mid-2000s.
An average couple would save less than $5000 per year.

So the difference between average and amazing investors is 4-to-1.
The difference between average and Mustache-level SAVERS is at least 10-to-1!!

So over the short time horizon we are talking about (7-10 years to retirement), you’ll get much better results by learning from this Blog (working on your spending), than you will by trying to be a fancy market-beating investor. That’s why I often repeat the message of “just pay off all your debts, than start throwing it all into the Vanguard index fund”.

Sure, it will go up and down with the broad stock index, but these are your retirement savings. You’ll  be living off of them for the rest of your life and while we can’t predict the future, we CAN choose the statistically best place to get a high long-term return. And that place is in a low-fee index fund.

Also, by wiping out your debt (including mortgage) early on, you are effectively investing in some guaranteed bonds: paying off a 5% mortgage guarantees you a 5% return forever*. With no mortgage or other loans, my family’s fixed costs are only a tiny fraction of what the typical indebted person needs to pull in. So there is lots of flexibility in when to sell off portions of the index fund for future living expenses. And the dividend checks keep coming every quarter, rain or shine.

Back to the point: by concentrating on SAVING  rather than minute details of investing, you are stacking the odds in your favor while also freeing up time for the real deal – maximizing your fun in a cash-efficient way.

 

* Although this is not an inflation-adjusted number, since if you leave your mortgage unpaid forever, the remaining balance will eventually deflate away to a very small number relative to the cost of other things. In other words, you may be able to pay off your $150,000 mortgage when you’re 100 with just the change in your wallet. But even 5% before inflation is still a good guaranteed return with today’s treasury rates. Cautious people like me are still wise to pay off their mortgages early.

  • Michael Keel May 28, 2011, 1:37 pm

    Enjoying your site. Got here from ERE.
    I do like your attitude.
    What happened to your mortgage?
    That would be a good story or maybe I missed that post!

    Reply
  • buzz September 22, 2011, 7:41 am

    Feel free not to publish this, but I just wanted to warn you about index investing. That note in every stock’s annual report: “Past performance is no indication of future returns” is just as valid with indexes. I’d encourage you to read Jacob’s thoughts on index funds: http://earlyretirementextreme.com/the-major-risks-of-buy-and-hold-index-investing.html

    Reply
    • MMM September 22, 2011, 9:30 am

      Thanks Buzz! I am more than happy to publish that.

      I think Jacob’s point is that if everyone blindly piles into index funds, the values will rise irrationally and thus not reflect the underlying dividends and earnings. In other words, we will all be buying like sheep at an overly high price-to-earnings ratio.

      But Jacob’s article was written in April 2008, when the market was 20% higher than it is today, and the earnings were 20% lower. The old sages of long-term investing suggest that buying higher earnings at a lower price is the real predictor of future returns, rather than focusing on share price alone. Some of the other little articles in the MMM “Investing series” talk more about this idea.

      I’ll read a bit more on Jacob’s ideas on value-in-the-whole-index and then ask him in person too.

      Reply
  • Katie October 16, 2011, 5:24 pm

    Just started reading your blog in chronological order and am really enjoying it!

    Question: you talk a lot about Vanguard index funds; is that an American thing? Any suggestions for Canucks?

    Reply
    • David April 23, 2014, 1:08 pm

      Not sure if you will see this but Vanguard has gone into Canada in the last couple years. They have several ETFs that are traded on the Canadian stock exchange.

      Reply
  • burntout October 24, 2011, 1:07 pm

    Average personal savings rate of 6% in the US! Dear God, where does the remaining 94% go?? I am shooting for a little more than a 6% savings rate. Here’s hoping I can make it happen.

    Reply
  • Agent9 January 12, 2012, 4:22 am

    ‘…paying off a 5% mortgage guarantees you a 5% return forever’

    This is before inflation. Should we adjust this number for inflation since we are comparing it to market returns of 7% after inflation?

    It will only return 5% until the end of your mortgage period as well. If you are 15 years into a 30 year mortgage then any payments will return 5% before inflation for the next 15 years.

    Reply
    • MMM January 12, 2012, 9:31 am

      Thanks, I fixed that detail with a footnote.

      Of course, the discussion could get more and more complicated: the 5% mortgage interest savings is better than a comparable 5% dividend, since it is effectively a non-taxable return (people enjoying Mustachian retirements are in a low enough tax bracket that they don’t benefit from the US mortgage interest deduction). And regarding the 15-year payoff: it is always possible to NEVER pay off a good chunk of your house by opening a line of credit and leaving the balance unpaid (pay only the interest).

      Still a good point nonetheless – thanks.

      Reply
      • Agent9 January 12, 2012, 10:03 am

        That’s a good point about the non-taxable return.

        I disagree with your point about using a line of credit to extend the life of the loan. That’s like saying a 5% return on a stock is 10% better than a stock that lost 5%. Remember that all mortgages only have the percentage cost due to the fact that they are amortized over a set period of time. Once you extend that time period you effectively change the rate.

        I hope this makes sense and doesn’t come off as being argumentative. I learn best through vigorous discussion.

        Reply
        • MMM January 12, 2012, 10:39 am

          Really? I don’t quite understand your point about how a line of credit is different from a mortgage. But since I don’t understand it, that does mean I could be wrong. Do you have a link to a longer explanation somewhere online where I could learn more about what I am missing?

          Here’s how I see it: Say you have a 200k house, paid off. Inflation is 3%. You can borrow money at 4%. Investment returns are 5% before inflation. To be simple, assume you can borrow 100% of the value of your house.

          If you take the full value of your 200k house and invest it somewhere a 5%, it will beat inflation.

          Meanwhile, you continue to pay only the interest on the line of credit. After 30 years, the balance feels like $200k/(1.03^30) which is about $82,400 because of inflation. Meanwhile, the borrowed principle generated enough cashflow to pay this 4% interest charge, and still grow at 1% before inflation.

          Since the outstanding house balance did not grow at all, and the invested principal grew at 1% after paying for the borrowing, the person came out ahead, right?

          Or even more simply, is my argument still incorrect that you can leave a balance outstanding forever and let it deflate away, assuming an imaginary world where the variable rates on a line of credit do not fluctuate in correlation with the federal funds rate? (or is THAT what you are talking about – the unpredictable variability of interest rates?)

          Reply
          • Agent9 January 12, 2012, 11:44 am

            The point I was trying to make about the line of credit versus the mortgage was that the line of credit doesn’t extend the mortgage beyond 30 years, it’s basically a new loan.

            The example you just posted talks about leveraging your house to invest and making a profit off of the spread in the two rates. My comment was in response to this part of your post:

            “…paying off a 5% mortgage guarantees you a 5% return forever.”

            My point was, your mortgage only lasts a fixed amount of time, say 30 years, so paying it off will not return 5% forever. It will only return 5%, before inflation, over the remaining life of the loan at the time you pay it off.

            Reply
  • CG January 25, 2012, 5:43 am

    MMM,I’m sure this question has been put to you before somewhere on your blog but I’ll ask it anyway. How do you justify investing in funds that fuel things you rail against on your blog?
    I have a significant amount of money I could invest but I don’t want to profit off of the consumerism and poor health choices of others or Big Oil and Big Pharm. Taking a quick glance at the Vanguard 500, those companies are in the top 10.
    Is there some mathy way that they don’t actually benefit from your investment?

    Reply
    • MMM January 25, 2012, 9:19 am

      Good question! It all depends on your strategy. If your goal is to use your money towards social change, there are several options. One is to avoid investing in socially destructive companies – this effectively raises their cost of capital ever so slightly, which will tend to slow their growth. You can do this by only buying “socially responsible” mutual funds.

      From the reading I’ve done, this “investment boycotting” tends to have a small effect compared to making changes on the consumption side. If you avoid BUYING things from the companies you don’t like, you make a much bigger difference by hitting their revenue stream, than you do by hitting them on the cost of capital side mentioned above. If you further make a point of writing letters to the company, and to newspapers, and organizing other consumers to pressure the companies to change their practices (tell Exxon to stop lobbying against climate change action, for example), you have an even bigger effect.

      You also have a big effect by voting for political leaders that value social equality and environmental concerns higher, and allow a lower level of cronyism and corruption. All of their problems aside, in the US this clearly points toward the Democratic rather than Republican party.

      When investing, I tend to seek out maximum return without too much regard to the companies that happen to be in the stock market index as a whole. Then I use these returns to give me the free time to make social change on my own. As odd as it may sound, this blog has allowed me to make much more change towards a more equal society than I could ever make by just buying socially responsible funds or living off the grid.

      Reply
    • Katie January 26, 2012, 10:23 am

      I’m really struggling with this ethical conundrum too. I don’t want to invest in big oil, pharma, defense, junk food, cigarettes, etc. I would feel like a hypocrite…I want to put my money where my mouth is.

      Currently I have my RRSPs invested through a really good advisor (this is before I started reading about low-cost DYI investing). I consider him “good” because he is willing to explain things well and values transparency – he discloses any benefit he will gain from anything we do, and points us to lowest cost options. He was also respectful of our wish to try ethical investing & he found us some reasonable options. The result has been that the returns are lower than your “regular” investments, but not by a lot…our advisor was pleasantly surprised.

      Another way we’ve been experimenting (ie, only using money we could “afford to lose” without much pain) with ethical investing was to buy some stocks in specific “green” companies (mostly wind, geothermal, LED tech, etc). Unfortunately we bought high on all of them and they have all taken a nose-dive since. We learned our lesson on picking individual stocks. I consider that money gone and will wait to see what happens over the long run.

      I do want to invest in low cost e-series index funds though, but I don’t know how to do it without investing in the bad guys. Any suggestions?

      Reply
  • Vick Desai September 17, 2012, 5:19 pm

    Mr MMM.

    I’ve been reading from the first blog on wards, and I have to admit, I’m now a fan. I truly enjoy the objective advice you are offering. I’m a recent college graduate who started working back in May. I finally saved enough in my stash to open a vanguard account. Instead of choosing the VFINX fund I decided to choose the VBINX due to it’s asset allocation. Although this may not be as aggressive as the VFINX fund, what are your thoughts on this particular fund?

    Reply
  • rubin pham October 5, 2012, 11:48 am

    although i have a lot of respect for warren buffet, i believe his investment method is no longer an effective one for 99% of american.
    i do believe your method is far superior to any investing advice.

    Reply
  • Andrea October 11, 2012, 1:44 pm

    when i started reading your blog i was sure that i would have to become an investment guru. i still plan to learn a lot more about investments but this post – “Why Hardcore Saving is much more Powerful than Masterful Investing” – has put my mind at ease. i really look forward to being student loan debt free (the only debt i have) and retiring early.

    Reply
  • Ed Mills October 30, 2012, 3:55 pm

    As an older reader of this blog, I’m a little late to the early retirement / financial independence party. However, over the last decade we (my wife and I–both teachers) have been able to play catch-up via hardcore savings and consumption moderation. I’m not as Mustaschian as some of you cats, but I feel downright gangsta when I think about how quickly we have acquired a ‘stache. Here is our stat line for the last decade*:

    $3,000 – 2002
    $30,000 – 2003
    $32,000 – 2004
    $50,000 – 2005
    $53,000 – 2006
    $60,000 – 2007
    $54,250 – 2008
    $62,095 – 2009
    $82,473 – 2010
    $82,850 – 2011
    $88,817 – 2012

    I agree with MMM 1 gazillion percent; hardcore saving will almost always trump you investing acumen. Save like there’s no tomorrow…actually check that…save like there are infinite tomorrows and feed you cost-effective investments (index funds, ETFs or target retirement funds–under 20 bips).

    * I always feel awkward talking about finances because it feels like I’m bragging. I post these numbers to illustrate the possibilities that result from a serious commitment to saving.

    Reply
  • Amanda April 15, 2013, 2:36 pm

    So to be clear, do you advise paying off your mortgage completely before beginning to invest? I’ve worked out that if I throw every extra penny at my mortgage, I can pay it off in just under 8 years… do I have to wait THAT LONG to get me one ‘a them nifty index funds?

    Reply
    • Agent9 April 15, 2013, 3:50 pm

      Why don’t you split it up your savings between the 2? As long as it’s in a tax advantaged retirement account. I think the point of this article is savings momentum trumps investing skills. I would put index funds in a retirement account under the savings umbrella versus trying to market time and individual stock picking.

      Even with index fund allocations, experts usually say the importance of stock to bond allocations whether it’s 50/50 70/30 or even 80/20 are miniscule versus just socking away as much as you can in the beginning.

      Reply
  • Amanda April 15, 2013, 8:05 pm

    Thanks for the reply! I know I wasn’t completely on topic – right after I posted my question I found this post: http://www.mrmoneymustache.com/2012/02/24/pay-down-the-mortgage-or-invest-more-a-winwin-question/ … But this was the burning question on my mind! I think you’re right, I’ll probably do both, putting more emphasis on the mortgage at least until I get a feel for investing (which I know nothing about and never even considered until I discovered MMM a couple weeks ago!)

    Reply
  • Johnny Shieh May 25, 2013, 6:07 pm

    Thanks MMM! I am working towards the MMM way of life as well. I have read many posts over the past few months, but only came across this one today. The comment I have regarding this post is, it is only for the starting process of the MMM way of life. In mid/later years of a person’s a career with accumulated assets of say, 1 million, the difference would be difference. 20% ROI (and what I read, it was 30+% for Warren Buffet) a year would yield 200k, where as 50k saved is still just 50k saved. With reinvesting gains over the next years, the compounded interest difference would be day and night. Of course, I do understand that very few can pick stock winners, but anybody can save if they try.

    Again, thanks a lot for this post. It reconfirms what I have been trying to achieve, provided more guidance, and gave me a lot of motivation to see a living example.

    Reply
    • Lewis November 11, 2013, 3:36 pm

      I think what he’s saying is that because the percent difference between the master and the average person is so much larger for savers than it is for investors, then your marginal return on time spent practicing toward mastery is much higher for saving. Therefore, you should become a master saver first. Once you’ve become a master saver, then you can spend the time becoming a master investor, if you wish.

      Reply
  • Kabamba January 4, 2014, 8:51 am

    I have come late to this (Savings) party but I am glad i am here. I have made my first 1 year savings commitment for 2014 and I have already kickstarted the party. In the 10 years, I am hoping to do Insane things when it comes to saving and I belive MMM will play a big role.
    Thank you for your work.

    Reply
  • David October 26, 2014, 11:15 pm

    “Also, by wiping out your debt (including mortgage) early on, you are effectively investing in some guaranteed bonds: paying off a 5% mortgage guarantees you a 5% return forever”

    If you are going to compare paying off the home to return on a bond – you buy the bonds with post-tax dollars, so its actually more than a 5% return when paying off the mortgage, because you’re not paying any tax on that fictional 5% return you’re getting. Its 5% * (1 + your marginal tax rate).

    Reply
  • Aaron Frazer October 28, 2014, 1:27 pm

    I believe the arithmetic presented here is misleading. If you save a multiple of what others do each year, ne year to the next is additive. IE if I save 10 times as much as you every year for 30 years, I end up with about 10 times as much money.

    By contrast, someone who generates a better return than most investors, gets a compounded, multiplicative effect. So getting 4 times the annual return of a typical investor ends up, after say 30 years, with much more than 4 times as much money, the formula is (1.2^30) / (1.05^30) = ~55. He would have 55 times as much money as someone earning 5% annual return.

    It is challenging (though admittedly not impossible) to save 55x as much money as other people year after year.

    And as you look at longer time frames you will need even more. Your savings are roughly a straight diagonal line, trying to keep up with a curve that bends upward.

    I agree that saving habits are very underrated, but I think the mathematical arguments presented here are specious. The bigger reason is that typical investors cannot, over a long period, beat the average returns. They should therefore focus their efforts on savings, where they have far greater capability to influence the outcome.

    Reply
  • Marsh November 22, 2014, 8:47 pm

    Mr. Money: I am curious about 401K and health insurance in terms of early retirement. So from earlier posts I saw that you and your wife still work part-time; how do you guys get health coverage? Also, if one wanted to retire early completely, how would they be covered? As for the 401K, even if you retire early you still have to wait till 65 to take it out right ? So how do you take advantage of that being so young? Finally, do you invest in a 401K on your own, since you’re not working full-time with a company?

    Reply

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