How much you save matters

It is important to increase your savings through your working life.

The amount of wealth you accumulate during your working life depends on two factors — your savings rate and the rate of return you earn on your investments. You can control your savings rate but not the return on your investments, as that depends on the market conditions. You should, therefore, focus on managing your savings rate to accumulate the wealth that you desire during your lifetime.

Human capital

Your savings rate is a function of your human capital risk or how variable your income stream is. Your ability to take risk is high if your income is stable. This means that you can invest in risky assets early in your career. A savings rate between 15 and 20 per cent of your monthly income would, suffice. This savings rate could also fit with your lifestyle needs. If you have stable income, chances are you will take a home loan, which would consume about 40 per cent of your total monthly income. This leaves you with 20 per cent of your income to meet current consumption requirement, after setting aside money for savings.

If your income stream is unstable, you should offset the high risk from human capital with low-risk investments such as bank fixed deposits. Since these deposits fetch low rates of return, your savings rate should be high. Specifically, you should save between 30 and 40 per cent of your income every month. Then, your entire income will be primarily divided into current consumption and savings; your unstable income makes it risky to take large loans including a home loan.

Savings growth

It is not enough if you save a fixed percentage of your income every year. You need to bridge the shortfall in your portfolio’s returns given the investment losses in any year. You can bridge the shortfall by increasing your investments in risky assets. But if your equity investments fall further, you may not only fail to achieve your objective, but the magnitude of failure will be large. That is, if you require Rs 10 crore to retire, you could end-up accumulating only Rs 5 crore.

You can instead increase your savings periodically to cushion the impact of shortfall in returns in any year. But you should increase your savings without reducing your current consumption. You would most likely receive a salary increase annually. So, save at least 10 per cent of your incremental salary; you can increase your savings every year as long as your income increases. You should set up a systematic plan to invest the additional savings and avoid the temptation to consume the entire incremental income.

A disciplined savings process is important. It is equally important that you route your savings into equity, bonds, gold and, if required, real estate through systematic investments.

(The author is the founder of Navera Consulting, a firm that offers wealth-mapping and investor-learning solutions. Feedback may be sent to >knowledge@thehindu.co.in)

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