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The typical investor should accumulate $3.7 million at an 8% annual rate. But the cost of intermediation – 2.5% – reduces that return from 8% to 5.5%. Due to the “tyranny of compounding costs”, the investor surrenders 80% of final wealth. You’ve heard it before – the key to building long-term wealth is to tap into the power of compounding returns. It’s a concept that’s universally accepted by savers, investors, finance professors, and math geeks. But for most of us it still requires a leap of faith because the math can be a little tricky. Anyone willing to devote 5 minutes to this topic will understand just how powerful compounding is. Why is this important? Because the power of compounding is a double-edged sword. Compounding growth (especially in a tax-deferred account like an IRA or 401K) will turbo-charge your wealth, compounding costs are a real drag. It’s important to understand how both of these forces work, and how they impact your portfolio. If you are an experienced investor, or someone who is good at math, you might think you don’t need to go through this exercise. But when it comes to the compounding cost part, you might be surprised to learn just how much of a drag it really is. In his book, The Battle for the Soul of Capitalism, Vanguard founder Jack Bogle made a bold statement. He said that thanks to the “tyranny of compounding costs,” investors leave 80% of their wealth on the table. I was more than a little skeptical – not about the nature of Bogle’s claim, but about the magnitude. Could it be true that investors leave 80% on the table? How does that happen? More importantly, why would any investor allow it to happen? Everyone knows that brokers charge commissions and advisers charge fees, but how much can those costs come to? Maybe 1% or 2% per year? How can that end up taking 80% of an investor’s wealth? Although I have always had great respect for Mr. Bogle, I wondered whether he might have overstated the case. So I set about the task of trying to debunk this astonishing claim. Much to my surprise, the claim holds up to scrutiny. To arrive at the 80% figure, Bogle used a very long investment horizon – 65 years. At first I thought, a-ha! Nobody stays in the market for 65 years! But after thinking about it I realized that it’s not only possible, it’s actually very plausible. Here’s how he arrived at the 65-year time horizon: A 20-year-old investor, just starting out on a long career Works and contributes to savings for the next 45 years, until age 65 Then lives another 20 years in retirement (actuarial tables say this is realistic) And doesn’t liquidate his holdings during retirement, but lives off of the interest on his principal At 85, leaves his nest egg to his children, after a 65-year investing career. Although this timeline is unusual, it’s not unrealistic. When making an argument, it’s completely legit to use best-case and worst-case scenarios in order to illustrate your point. So let’s stipulate that a 65-year horizon is acceptable for illustrative purposes. As you go through the charts and tables below, you can substitute your own likely time horizon for the 65 years that Bogle used. In constructing his argument in the book, Bogle states the following: “$1,000 invested at the outset of the period, earning an assumed annual return of, say, 8 percent would have a final value of $148,780 – the magic of compounding returns.” Here’s what that looks like in chart form. (You’ve undoubtedly seen this graph before, but bear with me – I’m establishing a baseline here.) (click to enlarge) Bogle then warns that this outcome is unlikely to be achieved. Why? Because the graph above excludes what he calls “intermediation costs.” And these costs also compound over time. Bogle’s argument is that the power of compounding returns is eventually overwhelmed by the tyranny of compounding costs – a concept that many investors fail to fully appreciate. Bogle continues… “Assuming an annual intermediation cost of only 2.5 percent, the 8 percent return would be reduced to 5.5 percent. At that rate, the same initial $1,000 would have a final value of only $32,465 – the tyranny of compounding costs. The triumph of tyranny over magic, then, is reflected in a stunning reduction of almost 80 percent in accumulated wealth for the investor… consumed… by our financial system.” Here’s what the tyranny of compounding costs looks like in chart form: (click to enlarge) As Bogle points out, financial intermediaries – the money managers, sellers of investment products and financial advisers – “put up zero percent of the capital and assume zero percent of the risk yet receive almost 80 percent of the return.” And it’s true – I ran the numbers six ways to Sunday and I came up with the same results every time. Now let’s take a look at the numbers from a different angle. Instead of using a static $1,000 deposit at the beginning of the period, I devised a more realistic scenario. The median household income in the U.S. today is $55,000. If we assume that this household sets aside 5% of that income each year, they will end up with a nest egg of roughly $800,000 when they retire after 45 years. And if they leave that money in their account for the next 20 years, only spending the interest on their principal, it will continue to grow, and their final account value will be roughly $3.7 million, using an 8% annual rate of return. That’s the power of compounding returns. Now let’s assume that the total cost of investing – what Bogle describes as financial intermediation – comes to 2.5% per year. This is a reasonable figure, based on many studies from academia and from the financial industry itself. When you combine the visible costs like mutual fund expense ratios, management fees, and account servicing charges, you get to 1.5%. When you add in the hidden costs, like the commissions that mutual funds pay to the brokers who execute their trades, trading impact costs, bid/ask spreads, capital gains taxes, and payment for order flow – you get to 2.5%. Now let’s see how much this typical household gives away to financial intermediaries – after 45 years, and after 65 years. (click to enlarge) After investing for 45 years, this household would – in theory – have accumulated a $798,000 nest egg. And if they kept their principal intact for the next 20 years of retirement, their nest egg would grow to $3.7 million. However, due to the tyranny of compounding costs, the financial intermediaries who “helped” them build this wealth would take 65% of their nest egg after 45 years, leaving them with just $278,000. At the end of the full 65 years, the financial intermediaries will have taken 78% of our household’s wealth, leaving them with $811,615. The true cost of financial intermediation is outrageous and unjustified. But most of these costs are hidden, which explains why so many investors aren’t aware of the destructive impact these costs have on their future wealth. In my next article on this topic, I’ll dig into the details of the costs to show you how they sneak up on us and overwhelm the power of compounding returns. In the meantime, I’ll leave you with a set of low-cost, high-quality mutual funds and ETFs that will help you cut down on the high cost of financial intermediation. I created this list using Morningstar’s fund screening tool. I screened for a combination of low expenses and high analyst ratings. It’s not a perfect list, and it doesn’t cover every asset class – but it’s a good place to start. If you own some funds that have high expenses, it might be worth your time to compare what you own to the funds shown below. Every dime you save on expenses gets moved from the intermediation side of the ledger to the wealth side. Think about it. (click to enlarge) Scalper1 News
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