*Disclosure: the implication of getting an extra $672,000 used in the title is meant just for effect and ties to an example used later on this post. It is not a guarantee of return and the reader should not assume he/she will actually get an extra $672,000 in retirement as a result of reading this and/or employing the services of a professional financial adviser. Also, just a heads up, I try my best to make my posts technical and action-oriented. This one is not as technical as I would like but is instead heavy on emphasizing the results of doing or not doing some high-level things. Ok, read on.
Perhaps the most interesting part of personal finance, and especially retirement planning, is investing (which, of course, isn't actually interesting at all to a lot of people). Most people, when the topic of financial planning or advising comes up, think of choosing and managing investments long before they think of life insurance or budgeting or tax-efficiency. This is completely understandable. Among other reasons we so often think of investing first:
- Investments and their movements are (usually) trackable.
- We can see current balances.
- The media consistently reports on what "the market" is doing.
- It's an easy way to socialize with our friends, family, peers, etc.
- Generally speaking, most people aren't comfortable sharing balances but are more than willing to share the high-level fact they are invested in stocks or bonds. Hearing and knowing that others are part of the same group and are impacted in similar ways by their movements is what helps make it interesting.
All of that is good and completely valid. Indeed, maximizing returns is vitally important to long-term success.
Why does it matter so much?
Consider this basic hypothetical.
Let's say that we have two people, Jack and John. They both happen to have exactly $100,000 in their retirement account(s) and are both going to invest without putting any more money in or taking anything out for the next 35 years. Let's say that Jack has average geometric returns of 6.5 percent and John has average geometric returns of 7 percent. Where do they land?
Retirement Account(s) Balance
Jack ends up with approximately $906,000 while John ends up with approximately $1,067,000. Of course, they are likely both generally happy with their account balance, to be sure. However, look at the stark difference in total dollars: roughly $161,000 - all because John had 1/2 percent better average return than Jack. Put another way, let's say Jack was able to replicate John's returns, he could have improved his balance to the tune of 18 percent.
So why does this matter? Well, because there are a number of ways to better your odds of success as an investor. Truth be told, there are dozens, maybe hundreds at this point, of good books on the subject, so we won't get into an extremely deep dive here, as you can find many resources that can probably do a better job than I can.
Some general ideas though:
1.) Be cognizant of cost.
This is not just choosing the least expensive investments, as is routinely assumed. Sometimes, often-times even, the more expensive investment approach can actually be more prudent. Rather, it's about being aware of all of your options and being cost-conscious. Many investment funds have almost exactly the same underlying investments within them as others do yet have drastically different costs.
Here's an example.
State Farm has an S&P 500 index mutual fund (SNPAX) that, as of this writing, has an expense ratio of .66 percent and may also have a 5 percent sales charge (often-times called a load). This fund seeks to track the S&P 500 by investing in the same stocks and their proportions of the S&P 500 index. Vanguard also has an S&P 500 index mutual fund (VFINX); however, it has an expense ratio of .14 percent with no sales charge ... and the expenses for similar funds can be even lower. So for almost exactly (outside of some tracking error) the same investment you can find a range approximately 1/2 percent in fees. To repeat what was found above, a 1/2 percent difference in returns can result in approximately 18 percent less dollars.
*The author does not hold either SNPAX or VFINX.
2.) Investment Strategy
Do you have an investment strategy? Is it written down? Can you tell someone what it is? Do you know how you'll react should the market go up 50 percent? What about how you'll react if the market goes down 50 percent? If you can't answer all of these I'd argue you don't really have an investment strategy.
This absolutely matters. This is one of those things that is a definitively good thing yet is nearly impossible to quantify the benefits of. It's probably not too dis-similar to physical exercise. We know it's generally a good thing to exercise, there are even many, very different exercise regimens that can work; however, to my knowledge, it's nearly impossible to precisely quantify how much a consistent exercise regimen actually helps. Same thing with an investment strategy. I have full conviction that, for the most part, those with, and especially those that consistently implement, an investment strategy will far outperform those without an investment strategy over the long run.
Vanguard developed a concept called Advisor's Alpha. It's admittedly not just about investment strategy but it does provide some relevant perspective. In it, Vanguard estimates that the value added by having a financial adviser can be approximately 3 percent in annualized returns over the long run. Now, reasonable people could disagree with the exact number but I personally believe that the number is positive in many instances.
We saw what happens with a difference of 1/2 percent. Let's see what 3 percent would do to Jack and John's balances.
You're seeing those numbers right. There is a dramatic difference. That might be an understatement even. We kept John's return (7 percent geometric average) and thereby his final outcome consistent with his prior numbers. However, we adjusted Jack's so that he trailed John by 3 percent annually (4 percent geometric average).
John ends up with the same amount of approximately $1,067,000 but Jack now ends up with roughly $395,000. That's a $672,000 difference. John has 170 percent more dollars than Jack due to those extra 3 percent returns.
Now, as I alluded to above, this 3 percent number comes from an assumption of using a skilled financial adviser. Inclusive in the Advisor's Alpha estimate are non-investment strategy items and besides, I'm not sure I fully believe that a financial adviser adds that much value in every single situation but, and this is just my own humble opinion, I do believe that in many cases this amount of value, and sometimes more, is definitely added.
That being said, the point here is that there is very likely a long-term positive impact created by establishing and steadfastly following an investment strategy.
Value add through an investment strategy? Highly likely yes. How much? Up for debate.
3.) Investing Tax-Efficiently
I preach a lot about the importance of tax-efficiency in terms of properly saving and then distributing assets. However, there is an entirely different (and additive) perspective on tax-efficiency. This concept can get complex but the core idea is that we should try to place the right types of investments in the right types of accounts and then buy/sell at the opportune times in order to take full - and legal - advantage of the tax code, all to minimize taxes. In truth, the practice is much more nuanced than that but the concept has real validity.
So it's a valid concept but how much value can be found by doing this effectively? Well, Betterment put together a white paper in which they determined that there is somewhere between .10 percent and .82 percent of annualized return that could, theoretically, be added using these principles, and in particular using their Tax-Coordinated Portfolio (which, of course, is available through DeBoer Financial as I use Betterment as a custodian - apologies on the shameless plug). These estimates are dependent on many variables, of course. You shouldn't take this as a guarantee of that much extra return as it's impossible to know the future. That being said, it should be stated that it would be imprudent to not try to tax-efficiently invest.
Let's take the middle ground of those two ranges, which is .46 percent; this is very close to the .5 percent number used earlier in this post. You'll note that the .5 percent difference in returns resulted in an 18 percent difference in aggregate dollars. There is, quite frankly, a ton of money on the line here.
There are many inputs into being an effective investor. I'd argue that the most important ones are cost-consciousness, strategy, and tax-efficiency, though the single-most important is strategy.
There's a significant amount of opportunity on the line. Our hypothetical friends Jack and John can attest to that.