Saturday, June 27, 2015

Financial Ignorance is Expensive and Definitely is NOT Bliss ... It's Not Even Close to Bliss ... $1 Million is More than Zero

It's not what we don't know that gets us into the most trouble financially. Instead it's what we don't even know that we don't know.

So in the interest of knowing, let's take a simple example involving two young and intelligent people who are beginning adulthood after having successfully completed their formal educations (which in all likelihood didn't include basic financial principles leading to much needed knowledge) and landing that coveted first job.

Both are smart people (aren't we all?) but only one has acquired a simple understanding of the rewards that will come from the benefits of early saving and investing over a lifetime.

Thus, we have two smart and well educated young adults. However, for illustrative purposes one is intelligent but financially ignorant and the other is intelligent and at least somewhat knowledgeable about basic personal financial matters. We'll call them FI and FK.

Both are 22 years old and entering adulthood with $16,667 resulting from savings, gifts or otherwise. As adults they are each free to do as they please with their newly acquired wealth.

Perhaps FI chooses to make a down payment on a new car, take an extended vacation, or just simply have a enjoyable time while promptly spending his 'windfall.'

FK, on the other hand, chooses to wisely invest his 'pot of gold' for the long haul in a diversified basket of blue chip dividend paying stocks.

Upon retirement 48 years later, they are each 70 years old. The result financially --- FI ends up with zero and FK has ~$1 million. But that's not the end of the story. Because even if FI had decided at age 22 to invest his pot of gold instead of buying that car and seeing the world, he's still likely to have seen his money grow only to ~$70,000 upon retirement. That $70,000 ending balance for FI stands in stark contrast to the $1 million now belonging to FK.  But how can this be, you ask?

Well, Vanguard Founder John Bogle explains hereinbelow why that's the case. {For the sake of simplicity, we've assumed that stocks will earn 9% annually over a long period of time, which is both logical and historically accurate -- in fact somewhat conservative.}

A Bogle insight that triples retirement returns highlights the dramatic difference between those ignorant about the benefits of investing early and for the long haul and those who both know and apply the basics:

"For millions of people, it's the real-world difference between retiring on time or working years longer than they had expected.

J.P. Morgan recently published data that shows a diversified portfolio over two decades returning a solid 8% annually to the investor. Yet the typical small investor in that same time frame actually experienced a dismal 2.5% return.

That's more than triple the difference! So what's going on here?

First off, small investors overpay dramatically for the advice they get. Then, unfortunately, they take that flawed advice and concentrate their investments into a narrow set of "bets" that fail to deliver — over and over. Things end very badly once you pile up two full decades of below-inflation returns. . . .

Vanguard Founder John Bogle's essential insight was that people didn't need or really want "outperformance" that increasingly few financial advisers could deliver. What they need are results. . . .

The two biggest drains on the long-term performance of a retirement portfolio are heavy stockbroker commissions and fees and losses from emotional trades that can result when an investment goes a direction we don't expect.

Low-cost portfolio investing, instead, is about finding the golden mean that results in a predictable, repeatable return. It also happens to produce a much higher sustainable return....

(The) Bogle . . . key insight (is) that (investment success) comes in two flavors: absolute and relative.

People focus a lot on absolute predictability. . . .

Relative predictability is a different beast. What it means . . . is that an investment behaves as expected relative to the wide variety of alternatives you might have chosen.

Cash is an investment. Stocks are an investment. Bonds, commodities, real estate, all investments. The really big risk question is, does your particular method of investing in these categories behave as expected? Is it relatively predictable?

There is a fine difference here, one a lot of retail investors miss. I'll give you an example: If you buy 10 stocks you have selected after much thought, there is a chance that your small slice of the equities market will outperform the entire stock market index, say, the Standard & Poor’s 500 Index....

There is also a chance that you will underperform the index. How far above or below your expectations is a matter of events and personalities and economic factors far, far beyond your ability to observe, much less control.

But, you're optimistic. Maybe it will work out great. Now, compare that to just owning the index and holding it over the years.

The events and personalities and outside factors begin to cancel each other out. After fees (and this is important), you are left with the performance of the entire class of investments. Now we're onto something that's relatively predictable.

That kind of predictability is found in portfolio-driven index investing. Speculating is a fine pastime if you have the money to blow, but most people want and need more security in their retirement planning.

It's perfectly understandable, yet seeking security and predictability also is the superior investment approach by far."

Summing Up

Over a long period of time, a basket of diversified dividend paying blue chip stocks has consistently earned an average annual return in excess of ~9%.

As Mr. Bogle points out, however, individuals who pay high commissions and fees while trading emotionally are likely to fall far short of that average annualized rate of return. They are also likely to invest in what they erroneously perceive to be 'safe' cash and bonds. They confuse risk with volatility. Accordingly, for the long haul their account will probably be lucky to generate average annual returns approximating 3%.

On the other hand, FK at age 22 is wise beyond his years. He understands that the compounding 'rule of 72' means that the initial $16,667 investment will double each time the product of the annual rate of return and the number of years invested is equal to 72. That's six doubles in 48 years at an annual rate of return of 9% (a doubling each 8 years) -- and that ends up being more than $1 million at retirement.

Our young and equally intelligent friend FI either doesn't know about the rule of 72 or chooses to ignore it at the tender young age of 22. That means he will have accumulated zilch or near zilch at age 70.

It's that simple. It really is. Choosing knowledge over ignorance is always the smart thing to do.

That's my take.

Thanks. Bob.

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