The Miracle of Compounding Interest and the Disaster of Compounding Costs

Compound Interest.

It’s been called the Eight Wonder of the World. Albert Einstein reportedly deemed it the greatest mathematical concept of our time.

Here’s how it works.

You take some money, say $1000, and put it into an account that earns interest. If you have an annual interest rate of 8%, after the first year you’ve earned $80. This gives you a total of $1080.

The second year, you get 8% interest again. Only this time, you earn 8% on $1080 (your original $1000, plus the $80 in interest you earned the first year). That means you’ll earn $86.40 in interest for year two, bringing your total to $1,166.40.

Do this for 30 years and without adding another penny to your savings you end up with over $10,000. Do it for 50 years and you’re close to $47,000.

If you add money to your original $1000 on a regular basis, then things really get interesting. Adding just $1000 a year (using the same 8% annual return above) will bring your 30 year total to over $132,000 and over $660,000 if you don’t touch it for 50 years.

While many investors are aware of the concept and benefits of compound interest, few give thought to the sinister forces of compounding costs.

An excellent article from the Consumerist shows how costs can add up over time . . .

"A 2006 study by Congress found that increasing fees by 1 percentage point results in you having 17% less money money when you retire.

In their example, put $20,000 in a 401(k) for 20 years and you end up with $58,000 if the fees are 1.5%. But if they were .5%, you would have $70,500. That's a lot of money. Increase the time to 35 years and what would be $220,000 drops to $163,000.

If you invest $1,000 at age 20 with an 8% return and 2.5% expense ratio, and just leave it there like that until you're 85, you will come out with $35,250, while your fund manager rakes in a cool $126,432."

That’s right, you’d be putting about 3.5 times as much money in your fund mangers retirement account than your own!

Two questions for you to ponder:
1. How are those seemingly small percentages you’re paying your 401(k) plan administrator and/or active mutual fund manager going to impact your ability to retire and the lifestyle you lead when you retire?
2. Are you doing more to build your nest egg or your money manager’s nest egg?

You can read the entire article from the Consumerist here.

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The Huge Gap Between Fund Returns and Shareholder Returns

They’re hard to ignore.

Those eye-popping returns featured in the ads for the mutual fund industry are very attractive. Why try to match the market when it looks like you can smash the market by investing in the right mutual fund?

Unfortunately, things are not always as they appear.

At a talk to the Financial Industry Regulatory Authority, John Bogle, the founder of Vanguard, shared some startling data.

Returns for the S&P500 from 1980 – 2005: 12.3%

Returns of the average fund from 1980 – 2005: 10%

And how well did investors do in that time period? No one knows for sure, but it appears they did much worse than 10%.

As an example of how bad investors might have fared in that time period, Bogle looked at the returns of the 200 funds with the largest cash inflows from 1996 – 2005. Those funds reported average returns of 8.9% for the period. The dollar-weighted returns (the returns shareholders actually earned) were an abysmal 2.4% - just 25% of what the funds themselves returned.

Of course the fund industry will say that it’s the investors fault for not staying fully invested during that time. Bogle has a different view however. He sites 3 main reasons that the mutual fund industry plays a big role in the dismal returns actually earned by investors.

1. “It was we in the fund industry who created those new funds that were to create such havoc for investors. As the market soared ever higher, we introduced those 494 brand new “New Economy” funds. Only a precious few of the major fund marketers had the courage to stand firm against the market madness, and forbear from creating and offering such funds.

2. When we had funds whose performance turned “hot,” we marketed them aggressively. Our public relations departments were willing co-conspirators with the press in establishing interviews with our “star” portfolio managers, many of whom, inevitably, turned out to be comets.

3. The higher a fund’s performance soared, the more we advertised our returns. Example: In March 2000, the month the market hit its high, there were 44 equity funds that advertised their performance in MONEY magazine. The average advertised annual return was +86 percent. Imagine! (During the next three years, these funds were to plummet by 39 percent.) Unsurprisingly, after the fall, in the October 2002 issue ofMONEY there were only four funds that did so.”

We have two lessons here:

1. Invest for the long term. Market timing does not work.
2. The “eye-popping” returns featured in the ads for actively managed funds are very misleading. The overwhelming evidence out there indicates that investors would be much better off investing in low cost, passively managed index funds.

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When Does 0.10% Really Equal 3.5%?

You're saving for retirement thinking your company has a great 401k plan.

In fact, the company even sends you a memo saying that they cut the fees on your plan to 0.10%.

Fantastic! You're socking away the savings. Fees aren't eating up your returns. You'll be able to retire in no time!

BUT (you saw that one coming) . . . that's not the whole story. In fact, it's not even close to reality.

A little digging around finds out that 0.10% doesn't account for all the fees you're really paying. You discover undisclosed expenses for management fees, commissions for buying and selling securities in the plan's mutual funds, revenue sharing, advisory services and more.

All of a sudden that 0.10% turns into 3.5%!

Seem farfetched? Well, that's exactly the situation an employee at one engineering company described in a recent Bloomberg article.

The sad fact is that most employees don't know they're paying any fees in their company's 401k. And only a tiny fraction go to the trouble of finding out what they are paying in fees like the employee featured in the article.

We constantly harp on investment fees because we believe there is no reason you should be paying as much as you are probably paying right now. Not only do fees eat up your returns, but there's no evidence the advice you are getting from your money manager(s) justify those fees by helping you beat the market.

The other important issue to note is that the employee in the article has plans to retire this fall but now, in part to the high fees he's been paying all these years, he's not sure he'll be able to. It's easy to get caught up in all the numbers and statistics in investing (in fact, Wall Street's counting on you doing that) but there are serious, real life consequences at stake.

The article reports that an extra 1% in fees can decrease your returns by 15% over 30 years. So say instead of $1 million at retirement, you only have $850,000. What does that lost $150,000 mean to you in real terms?

Having to work longer than you want to/plan to?
Not leaving as much behind to your children/grandchildren as you planned?
Not having enough to leave a bequest to your favorite charities?
Cancelling your plans for that dream vacation you want to take when you retire?

Maybe you feel it's not worth fighting for an extra percentage point here or there - but how about fighting for an earlier retirement, dream house, or dream vacation?

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How To Weather the Recent Stock Market Turmoil: Think Climate Change

Since we posted about investing in down markets last October, things have gotten much uglier in the financial markets.

Listening to the Chicken Little financial pundits scream “The sky is falling, the sky is falling,” it’s tempting to take your money out of the markets and stuff it in your mattress.

It’s not easy to watch the value of your investments sink like lead. However, the advice we gave in October still holds true. Investors who keep investing during a falling market can really pad their long term returns.

Try to remember that what happens from day to day, or even month to month, in the stock market is weather. As a long-term investor you should not be interested in weather, you should be interested in climate change.

And over the long term, investors who don't panic during the inevitable market downturns and stick to their target allocations will be duly rewarded.

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How Small Percentages Add Up To Big Money

Is 1% small percentage?

That's what Wall Street and money managers want you to think.

They count on the phobia most people have of math to get investors to believe the few percentage points they charge for their "expert" money management skills is small potatoes compared to the huge sums of money they can make you (never mind that there's no evidence to show money managers can outperform the market - but that's another blog post!).

But just that little 1% can easily cost an investor tens or hundreds of thousands of dollars in lost savings.

Here's an excellent example from the book "Stop the 401(k) Rip-off!" that shows how (while this example uses a 401(k), other than the employer match in this example, the math holds true whether you have your money in a retirement account or not):

Say you have $75,000 in a 401(k). If you could reduce your 401(k) expenses by just 1% a year, that saves you $750. Not bad, but that probably isn't going to make or break your retirement.

But each year, you're adding to your 401(k) balance (at least you should be!).

So if you're contributing 10% of a $50,000 salary, that's an additional $5000 a year going into your 401(k). Add an employer match of $2500 and that makes it $7500 a year. After adding that $7500 and your portfolio going up 7% (a little below the historical stock market average), a year later you now have $87,750 in your account.

But now your fees have increased from $750 to $877 – an increase of almost 17%!

Add the magic of compounding and ten or twenty years down the line your 401(k) could easily be worth $250,000 to over $1,000,000. That 1% is now costing you $2500 to over $10,000 – every year.

Could losing that much each year make or break your retirement?

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Bond Fund Debacle

A recent article in PLANSPONSOR magazine provides a stunning real world example that illustrates the pitfalls of owning a bond fund.

It involves 2 institutional commingled trust funds offered by State Street Global Advisors (SSgA) that were deemed "conservative" investments managed by an investment firm that is "risk averse."

The investments in question are the SSgA Intermediate Bond Fund and Government Credit Bond Fund.

According to a complaint filed in the District Court for the Southern District of New York against SSgA, that in July and August 2007 the Intermediate Bond Fund lost 12% (while its benchmark index rose 3%) and the Government Credit Bond Fun lost a whopping 25% during those two months (it's benchmark index rose 2%).

A few month ago we wrote about why you should never buy a bond fund.

In a nutshell, a bonds place in a portfolio is to provide certainty. Bond funds deprive investors of that certainty.

The SSgA example shows us that when you need a conservative, safe, risk averse investment that brings some certainty to your portfolio, lay of the bond funds and stick with good old US Treasuries.

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The Real Secret to Making Serious Money on Wall Street - Work There!

Despite shareholders in the securities industry losing $74 billion in equity this year, Wall Street will still be paying out record bonuses to their employees of around $38 billion for 2007. This according to a recent article from Bloomberg.

And those are just the bonuses paid to employees of Wall Street's five biggest securities firms - Goldman Sachs Group Inc., Morgan Stanley, Merrill Lynch & Co., Lehman Brothers Holdings Inc. and Bear Stearns Cos. (The $38 billion doesn't include the bonuses paid to hedge fund managers, mutual fund managers, money managers, etc. in the hundreds of other investment firms investors entrust with their money.)

Where does the bulk of this bonus money come from? The excessive fees charged to the investors who lost $74 billion in equity this year.

It's the Wall Street way. You win, they win bigger. You lose, they still win big.

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