Why you should stop trying to beat the market

@Money October 25, 2011: 11:32 AM ET
investing vs. saving, investment returns, retirement

Finding the right balance between investing and saving will reap retirement rewards.

(MONEY Magazine) -- How much better will you do if you invest well instead of poorly (or earn the average)? -- James McGrath, San Marcos, Calif.

Considering all the attention investment pros (and financial magazines) lavish on picking the right stocks and funds, I can understand why you might think superior investing ranks above all else when it comes to a `secure future and a comfortable retirement.

Savvy investing is certainly important -- you don't want to blow your savings on lousy funds or ineffectual strategies. And you'll end up richer if you happen upon a winning investment. If you'd owned the Sequoia Fund for the past decade, for example, a $10,000 balance would have grown to more than $16,000 now, vs. $12,800 if you'd simply earned the market return.

But as a practical matter you can't know in advance which fund or stock will beat the market -- in fact, over the past 15 years, only 55% of U.S. equity funds did so, according to Morningstar. Rather than pinning your hopes on higher returns, I'd say boosting your savings rate is a surer way to improve your retirement prospects.

To see what I mean, check out this example. Let's say you're 35 years old, earn $60,000 a year, and sock away 10% of your salary (including your company match) into a 401(k) that's already worth $75,000. And assume you're stashing your retirement moolah in a diversified portfolio of 60% stocks and 40% bonds.

What to do with $1,000 now

You're doing a reasonable, though not spectacular, job of preparing for retirement. Your savings rate is decent, though it could be better. As for investing, you're hardly a slouch, but ideally you should be devoting more of your 401(k) to stocks.

The key is starting with an overall plan -- that is, deciding on the appropriate asset allocation, or blend of stock and bond funds that makes sense given your age and stomach for risk.

Indeed, when the folks at T. Rowe Price ran the numbers on this saving and investing regimen, they projected that you'd have a 68% chance of accumulating enough money to retire in 30 years on 70% of your pre-retirement income and not deplete your funds until age 92.

Not bad. But if you could do just one thing to improve your outlook, what would it be? Save more or earn more?

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You can't, of course, say you'd prefer an 8% annual return instead of 6% and turn a dial higher to get it. The investing world doesn't work that way. So to try to earn more you have to invest more aggressively.

In this example, both increasing your savings rate from 10% to 12% and shifting to a more growth-oriented portfolio that's 80% stocks and 20% bonds --an appropriate mix for a 35-year-old -- will boost your chances of retirement success. But saving more has a larger effect than earning a higher return would.

In the real world you're not limited to one move. You can bump up the amount you save and improve a sub par investing strategy. Do both those things -- which, ideally, you would -- and you can feel even more confident about achieving a secure retirement.

In theory, later in your career, when you're more likely to have a large balance in your retirement accounts, a relatively modest increase in your rate of return could boost the size of your nest egg more than upping your savings rate would.

On a $500,000 portfolio, for example, an additional half percentage point of return would translate to an extra $2,500 a year, more than someone earning $100,000 would get by moving from a 10% to a 12% savings rate.

Trouble is, the more risk you take in pursuit of loftier gains, the more your returns will jump up and down from year to year, and the harder your portfolio will get hammered during market setbacks. Take a 55-year-old a decade from retirement -- for that person, a pedal-to-the-metal approach is no help. Because you have less time to recover from a setback, it slightly cuts your chances of reaching your goals.

Simplify your retirement savings

That said, you still have one way to effectively earn more on your portfolio --without ratcheting up risk: Pare investment fees.

Annual expenses for stock funds average 1.5%, while the yearly tab for bond funds comes in at roughly 1%. By opting for low-cost options like index funds and exchange-traded funds, which often charge less than 0.5% annually, you may be able to reduce your costs by anywhere from a half to a full percentage point a year. Over the course of a career, that can boost the eventual size of your nest egg a good 10% to 20%.

Finally, there's one more compelling reason not to rely on astute investing. Given the sluggish growth and onerous levels of government debt here and abroad, even the most savvy investors may have to settle for relatively modest returns. That could be a major problem if your retirement security hinges on racking up big gains. Boosting your savings rate is a surer way to increase the ultimate size of your portfolio.

So by all means, make sure you're investing as well as you can. If you really want to improve your prospects, though, save more. To top of page

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