How to Add a Half a Million to Your Retirement Account by Cutting not Adding

I’ve been trying to come up with a scenario that fairly represents the difference one percent makes over our investing lifespan using as an example, two employees who systematically put the same amount of money away for retirement and then spend down those assets during about two decades of retirement.

The Scenario

It starts with two 30 year old employees who work until their full retirement age of 67. The first 20 years they invest in an 80/20 portfolio of stocks to bonds, starting with nothing and adding $750 a month (1/2 of the current contribution limit). At 50 years old, the mix is changed to 50/50 and again using 1/2 of the current contribution limit plus the catchup provision, which totals $1,000 a month. Finally, our representatives live another 18 years in retirement, so at 67 the portfolio allocation is again changed, this time to 20/80 stocks to bonds. It is also assumed during retirement they each receive monthly cash distributions from the portfolio. The return figures used are historical averages (see notes for detail) and inflation was taken into account using a 2 percent annual increase.

There is one key difference in the two portfolios, one was charged 27 basis points (0.27%) in fees using a passive funds strategy and the other was charged 1.27 percent for an actively managed funds portfolio. Effectively a one percent difference over the 55 years our investors were invested.

The Results

Over the first twenty years, from ages 30 to 50 the portfolios grew to $374,506 for the passive portfolio and $332,515 for the active portfolio, remember the only difference affecting return is the fee. Over the next 17 years leading to retirement, the passive portfolio ends up with an inflation adjusted $1.27 million while the active portfolio maxes out at $1.01 million. Again the difference is only due to fees. At 67 our retirees begin taking monthly withdrawals, the passive investor takes $6,500 a month for life and dies at 85 with about $430,000 left for heirs, charity or her dog. The active investor cannot take as much or the portfolio would be depleted prior to age 85 and instead takes $5,788 a month so that the portfolio is worth zero at death.

The one percent cost difference to an investor under this scenario over a 55 year period is well over $500,000. Over the 37 years of employment that little one percent fee difference accounts for a 30 percent difference in the amount of capital growth in the portfolios. During retirement the difference in fees is the difference between taking $78,000 out each year and having some capital assets left – comfy with some breathing room - or taking $69,450 out each year with nothing left at the end – live past 85 and its Social Security.

These results are only one of near infinite scenarios depending on when you start investing, how long you work, how much you put away, etc. The important takeaway is that lower fees mean better return probabilities for investors, irrespective of your age or dollar amount of your assets. In other words the less you pay the more you keep. This post does not even take into account that active fund managers have underperformed passive funds across most fund categories over longer-term time periods (10-15 years), making the case for low-cost passive investing even more compelling.* Although in theory the case for active management seems intuitive, the actual track record of most actively managed funds is underwhelming.

As always, seek the help of an accredited professional when it comes to your financial future.

CBlakely CFP®, CTFA          04/2015   

Notes: Inflation assumption - 2 percent per year. Historical returns: 80/20 portfolio 8.92% annually, 50/50 portfolio 7.71% annually and 20/80 portfolio 5.72% annually. Time value calculations used monthly compounding, and retirement calculations used sequential cash flows all with the same value (annuity).

Although the author (me) believes in the veracity of the formulas and results, these numbers have not been subjected to review and may contain errors.

Source: *The Case for Index Investing – Vanguard White Paper March 2015

Active v. Passive - The Secret to Winning the Loser's Game

This is the final post on active v. passive investing but before moving on let me briefly summarize.

• Academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest. Index funds should form the biggest part of every portfolio.
• Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
• The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.

But the cap-weighted index isn’t perfect and, depending on how much risk you’re prepared to take, you may want to tilt the portfolio towards other types of risk, or beta, such as small company or value stocks.

Again beta is a measure of overall market risk. But what about alpha? That’s the name given to any return provided by an investment over and above the benchmark index.

First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?

Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy.”

Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him?”

Much evidence is stacked against active fund management. But, say for example, in spite of everything academia has said, you still want to take a gamble with part of your portfolio, how do you choose an active fund from the thousands of funds available?

Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do.”

Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.

Like Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written. In it Graham wrote that investment is most intelligent when it is most businesslike.

In his preface to the fourth edition of the book, Buffett said: The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

Whichever route you go down - passive, active or somewhere in between - your behavior is absolutely critical - particularly at times when emotions are running high. Everyone knows the idea is to buy low and sell high, but time and again we do the precise opposite.

Many investors pile in just as the market reaches a top. Then, even worse, they bail out just as prices reach the bottom and are bound to rise again. That kind of behavior is sadly all too typical, and even the professionals are prone to it. The effect on the long-term value of our investments can be catastrophic.

So, how do we as investors curb that sort of self-destructive behavior? Well, one way is to have an automated approach to investing. So, once you’ve chosen a strategy and the level of risk you’re prepared to take, you leave your investments exactly as they are. Either once or no more than twice a year you should rebalance your portfolio to realign it with your risk tolerance. But again, this can be done automatically.

Merryn Somerset Webb from MoneyWeek says, “There are lots of styles that work over the long term. Value works, dividend investing works, momentum investing works if you get it right. All sorts of things work. But they only work if you stick with them."

It also helps to have a financial adviser to keep you on track. Charles Ellis says: “There are two main roles for an adviser. One is to help individuals understand themselves and what their real financial purposes are, and what their anxieties would be. And the second is to hold the client’s hand and encourage them to stay in it for the long term.”

Vanguard founder Jack Bogle says: “Why in the name of peace do we pay any attention to the stock market? It's a giant distraction to the business of investing.”

Of course it doesn’t help that we’re constantly hearing about the markets. There are specialist magazines. Almost every major newspaper has a money section. There are radio shows and, of course, entire television channels devoted to the latest on the markets and where the so-called experts think they’re heading.

And that, in a nutshell, is the secret to winning the loser’s game. First, choose a strategy that’s based on evidence - ideally one designed to capture the returns of the whole market - and then tailor it to your attitude to risk. Secondly, stick to your strategy through thick and thin. Rebalance your portfolio, yes, but most important of all, stay the course.

CBlakely CFP®, CTFA        02/2015

Sources: Winning the Loser’s Game – Charles D. Ellis;  Robin Powell: How to Win the Losers Game – SensibleInvesting.tv Link to the video