Friday, 31 May 2013

Investing Big Stuff vs Small Stuff

We've all heard the expression "don't sweat the small stuff", a wise admonition to focus on what is important. But what is the big important stuff when it comes to investing? In today's information age, there is a deluge of data and advice that can easily confuse and mask what really makes a difference to our long term lifetime (say 30 or 40 years) investing prosperity. Therefore, today we will take a shot at identifying the key issues and quantifying their impact.

#1 Not Saving Money - Impact = 100%
It's almost embarrassingly obvious but if there is no money set aside out of income for investment, there can be no growth. The more savings, the greater the eventual total. Moreover, the earlier in life that money can be set aside, even small amounts, the more time that the benefits of compound growth can accumulate (earnings reinvested generate more earnings - see the difference compounding makes in Fidelity's growth calculator).

#2 Chasing Performance or Headlines - Impact = 3 to 5% per year
This is another story familiar to, and sadly applicable to, many investors. Buying into funds or stocks that have done really well recently, only to see subsequent stagnation or worse, losses, as performance cools off. The evidence comes from numerous sources, one well-known example being the annual reports by Dalbar Inc, which document (e.g. the 2013 press release which showed 3.96% under-performance of US equity investors) that investors have chronically under-performed the funds in which they have invested through poor timing.

Another way to see the issue is the panel insert "Dangers of Market Timing" within the superb Big Picture inter-active chart of the TSX going back to 1935 at the Get Smarter About Money website of the Investor Education Fund. There was about a two and a half times difference in total growth between being continually invested in the stock market and missing the best year in a ten-year period (which would be akin to waiting till after the good year to decide to invest).

#3 High or Low Fund Fees - Impact = 1.5 to 2% per year
Funds on average under-perform more or less by the amount of their fees and costs (management expense ratios and trading costs) as shown in many sources, for example, David Swensen's book Unconventional Success. A handful of funds do outperform, justifying their high fees, but they are very hard if not impossible to identify beforehand. The easier, effective solution is to search out funds with low fees, which most often are index funds passively tracking broad markets. Since fees are based on assets, not returns, they take a chunk away from the investor every year. It is a very predictable return reduction, year after year. Our estimation of the return difference is based on the spread in fees between high-fee and low-fee funds.

#4 Utilizing RRSP, TFSA Tax-Advantaged Accounts - Impact = 1 to 4% per year
Every Canadian investor should take advantage of RRSPs (in any of their various forms like LIRAs, LIFs, RRIFs etc) and TFSAs. (We previously explained in this post why taxable accounts do not produce as much after-taxes as RRSPs and TFSAs.) Withing such accounts, the capital gains, interest and dividend returns are tax-free so the investor benefits by the amount of his or her tax income tax rate times the return. An Ontario taxpayer in a 35% bracket on a 6% pre-tax annual investment return would gain about 0.35 x 6% = 2% per year. The higher the tax bracket and the greater the investment return inside the RRSP/TFSA the bigger the benefit.

That a TFSA produces tax-free returns is very obvious but for a RRSP how this works can be confusing. For a fine explanation that separates the mechanics from the financial reality, see's Nitty-Gritty of the RRSP Model).

#5 Creating Diversified, Rebalanced Portfolios with Efficient Funds - Impact = 1 to 2% per year
The last 60 years of financial research, beginning with Markowitz's 1952 seminal paper Portfolio Selection, have shown that combining different types of assets, especially stocks and bonds, with proportions that are set according to the investor's risk requirements and then rebalanced regularly to maintain the risk level, perform better. Beyond the basic level, further benefits can be obtained by adding other assets like real estate and commodities or subdividing stock holdings into geographies, such as domestic market, developed country and emerging market, and into types like small cap, value and momentum.

Finally, and still not mainstream, but supported by a growing body of research that this blogger believes, alternative selection and weighting schemes like low volatility, equal weight and fundamental factor offer opportunity for further portfolio performance enhancement. The alternative scheme effects only reliably happen over decades long periods so the investor must be very patient and determined when the odd decade of under-performance relative to traditional standard cap-weighted indices goes by.

Wealthfront's Investment Methodology outlines the case for diversified rebalanced portfolios up to but not including the alternative weighting schemes, which can be found analyzed in Jacques Lussier's recent book Successful Investing and on the EDHEC Risk-Institute.

Translating the Impact into dollars
The graph below shows how much difference each percent makes to the total compound growth of investments over the long term, such as thirty or forty years. Adding up the lower end values for items 2 to 5 gives us a 6.5% difference, the gap between 0.5% and 7% annual growth, which ends up being in excess of a 12x difference after 40 years - $149,700 vs $12,200.

The longer the time period and the more Big Stuff items the investor takes advantage of, the greater the ultimate difference. Readers can test other combinations of contributions, time period and return differences in Fidelity's online calculator linked above.

(click to enlarge image)

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

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