Early in a new year is a terrific time to take some additional control of your investments, and the payoff could be worth an extra $1 million or more when you’re ready to retire.
In this article I’ll show you three ways to do that, along with the potential payoff for each one.
So you don’t have to peek ahead, here are my three suggestions:
Diversify 75% of your portfolio away from the S&P 500 index SPX, -1.74%.
Reduce or eliminate Wall Street’s recurring fees.
This article is about the accumulation phase of investing during which you are saving (you ARE saving, right?) for retirement.
To do the numbers, I’ll assume you are putting away $6,000 a year into a Roth IRA, and you have a 40-year accumulation period.
With each of these three variables, the longer your time frame, the greater effect you’re likely to get. Over 10 years, the difference will be there, but it might not bowl you over. (That’s just how compounding works.) However, over 40 years, the differences are huge.
The following calculations are based on market returns from 1970 through 2009, a period that included plenty of ups and downs and surprises, both favorable and unfavorable.
In every case, we’re assuming 40 years of $6,000 investments — a total of $240,000 that you make.
Let’s compare investing 100% in equities vs. a more conservative mix: 60% equities, 40% bonds. For this comparison, “equities” will mean the popular S&P 500 index.
In the 60/40 mix, your $240,000 grew to be worth $2.69 million. You had to withstand eight years of stock-market losses. But in four of those years, your annual addition of $6,000 kept your portfolio value from going down year-over-year.
Still, the market’s major losses in 2001, 2002, and 2008 took a significant toll.
If your portfolio was 100% equities instead, at the end of 2009 you had $3.18 million — an additional $420,201. The difference was more than all the money you invested over the years.
However, that extra return came at a cost. In seven calendar years (instead of only four), your portfolio value declined from one year to the next. And even though you might have stayed the course, you could never have known that you would eventually come out ahead.
Over the long run, a four-fund portfolio of major U.S. equity asset classes has outperformed the S&P 500. This portfolio is made up of equal parts of large-cap blend stocks (the S&P 500, in other words), large-cap value stocks, small-cap blend stocks and small-cap value stocks.
In the 40 years under examination here, a portfolio allocated 60% to those asset classes and 40% to bonds would have grown to $4.18 million. And an all-equity version would have been worth $6.52 million.
That’s an extra $3.34 million (all-equity portfolio) or an extra $1.49 million (60% equities). The additional money resulted from only one thing: changing the way you invested 75% of the equity part of your portfolio.
Cut out the middleman — Wall Street
I want to start by quoting Jonathan Clements from his excellent book, How to Think About Money:
“The logic of investing is brutal. Before costs, investors earn the market’s return. After costs, we must — as a group — lag behind. In fact, we collectively trail the market by an amount equal to the investment costs we incur.”
It’s very common for investors to pay 1% to 2% a year for active management and/or the services of an adviser. However, it’s not that hard for many investors to cut their expenses by 1%.
A single percentage point doesn’t seem like much in a single year. But over a 40-year period, it adds up to much more than you probably realize.
Using the Merriman Education Foundation Lifetime Investment Calculator, we figured out the cost of a 1% annual drain on the four scenarios I just laid out.
Here’s what that 1% a year would have cost:
Table 1: 2009 year-end values, after 40 years, in millions
S&P 500, 60/40
S&P 500, all equity
Four funds, 60/40
Four funds, all equity
After 1% expenses
Source: Merriman Financial Education Foundation
In each of those four cases, the 1% annual expenses reduced the 40-year payoff by about 25%.
But when you count up the dollars, the effect of that 1% drag is stunning.
Over 40 years, while you were diligently setting aside $240,000, Wall Street was quietly taking a cut of $680,000 (S&P 500 at 60/40) to $1.69 million (four-funds all-equity).
That “cut” was the result of only one thing: a 1% reduction in your annual return.
You saved and invested the money. You took all the risk. Do you really want to give up one-quarter of your results to Wall Street in unnecessary expenses?
Unfortunately, it only gets worse. Assuming that you leave your money invested over a retirement of 20 to 40 years, you will pay out a lot more to Wall Street. It will happen silently and relentlessly.
I’m not saying you shouldn’t have an investment adviser working for you. There are very valid reasons for doing that. But in order to reap the full rewards from the money you set aside and the risks you take, you have to reduce your expenses every way you can.
The best way to do that is to invest in index funds, eliminating the costs of hiring active managers, turning over your portfolio, and chasing the expensive and usually futile quest to beat the market.
In addition, if you invest in index funds, you won’t look like a good prospect for salespeople peddling expensive, risky investment products. And because index funds are relatively boring, they will keep you insulated from the temptations of market timing and stock picking.
Richard Buck contributed to this article. Paul Merriman and Richard Buck are the authors of We’re Talking Millions! 12 Simple Ways To Supercharge Your Retirement.