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(Wall Street Journal 7-27-99, By Jonathan Clements)
If you think investors are rational, consider the following
dilemma.
An investment portfolio's growth is driven by how much we
save, how long we invest, what return we earn and how much of that
return we surrender to investment costs and to taxes. Think
of this as your formula for investment success.
We have an enormous amount of control over every factor in
the formula, except one. So guess which factor consumes most
of our energies?
Yup, you've got it.
Investors spend an absurd amount of time trying to control
the one think they can do the least about, which is their raw
investment performance. They attempt to pick hot
stocks, find star fund managers and guess the market's direction. Yet it is extraordinarily difficult, if not impossible, to do any
of these things.
"People focus their energies purely on their rate of
return, and not on areas where they can make a difference,"
says Art Canter, an investment adviser in Boca Raton, FL.
Maybe it isn't surprising that we devote so much time to
boosting our raw returns. After all, it is a critical
ingredient in our investment success.
Just because it is critical, however, doesn't mean we can do
much about it. The reality is, we can help our portfolio's
growth far more by increasing savings, investing longer and
cutting investment costs and taxes. "You need to
maximize each of those to their full potential," says Richard
Van Der Noord, a financial planner in Macon, GA.
You might turn time to your advantage, by both starting to
save earlier and also delaying the eventual expenditure. Consider, for instance, what happens if you put off retirement for
a few years. First, you have longer to save. Second, your savings have time to earn additional investment
gains. Finally, you shorten your expected time in
retirement.
Similarly, you could crank up the amount you save each month
and cut costs, by favoring mutual funds with lower annual expenses
and using a discount broker when buying individual stocks. "Most of us, if we really got serious about it, could
increase the amount we save," Mr. Van Der Noord reckons.
He adds that there is plenty of room to eliminate the drag
from taxes, by making full use of tax-deferred savings accounts
like 401(k) plans and individual retirement accounts. "Ironically, the area where people feel they have the least
control, taxes, is where they have the most control," he
says.
Investors may also be able to bolster their raw investment
returns, but not in the way they think. Rather than trying
to pick market-beating stocks and funds, investors could simply
boost the percentage of their portfolio devoted to stocks. If you shifted from a mix of 50% stocks and 50% bonds to a
portfolio that is 60% stocks and 40% bonds, you increase your
expected annual return by maybe half a percentage point.
That small adjustment can make a huge difference to your
eventual wealth, especially when combined with increased savings,
more time and lower investment costs.
How much are such changes worth? Imagine two investors
who are saving for retirement during a period when stocks deliver
11% a year and Treasury bonds return 6%. Both investors are
funding individual retirement accounts, so neither is paying taxes
on each year's investment gains.
Our first investor saves $100 a month for 30 years. He
keeps 60% of his portfolio in actively managed stock funds that
levy 1.4% in annual expenses, close to the average for diversified
U.S. stock funds. The rest of his portfolio, 40%, goes into
Treasury bonds. Our first investor believes he can get an
edge by picking superior stock funds.
Our second investor, meanwhile, doesn't have any confidence
in his ability to pick superior funds, so he puts his stock-market
money in a market-tracking index fund that charges 0.2% a year. Instead, our second investor focuses his energies elsewhere.
For instance, he decides to raise his stock allocation to
65%, with just 35% going into Treasury bonds. He also cranks
up his monthly savings to $105, and he starts saving for
retirement two years earlier, so that he has 32 years to invest.
Result? Our second investor has about $220,000 at
retirement. To amass the same amount, our first investor
would have to pick stock funds that, before expenses, beat the
market's 11% return by more than three percentage points a year.
What are the chances that, for 30 years, our first investor
could keep his money invested with managers who beat the market by
that much? "Nil," Mr. Canter says. "There could be money managers who have done that over the
last 30 years. But . . . that doesn't mean they'll do it
again. Besides which, they'll probably retire."
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