Back to Basics with John Bogle - Pillar 3

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Back to Basics with John Bogle - Pillar 3

Post by pkcrafter » Thu Jul 26, 2007 9:23 am

BACK TO BASICS - PILLAR 3
The Vanguard Diehards forum has a well-earned reputation as one of the best investment resources on the internet because of its long history of attracting and helping newer, inexperienced investors. The seeds of success have grown from the fundamental teachings of our mentor, Jack Bogle. I feel our mission has been, and continues to be, to pass along the wisdom of Mr. Bogle.

In recent years, the forum has also attracted more knowledgeable investors who enjoy discussing sophisticated ways to reduce risk and/or increase investing returns. This is interesting and educational for knowledgeable and experienced investors. However, our advanced discussions are sometimes confusing and possibly even overwhelming for newbies and less-experienced investors. As a result of these more sophisticated conversations (about which experts often disagree), it is not unusual to see new investors with a few thousand dollars trying to start with complicated slice-and-dice portfolios.

I discussed this problem with Mel and Taylor with the idea that the best way to help new and less sophisticated investors would be to post a series of conversations that will bring us back to Jack Bogle's common sense, easy-to-understand ways to invest successfully. Mel and Taylor agreed and suggested I review each of Jack's "12 Pillars of Wisdom."

The 12 Pillars were originally published in 1994 as an Epilogue in Mr. Bogle's first book, Bogle on Mutual Funds. I am posting a series of conversations featuring each of Mr. Bogle's "Twelve Pillars of Wisdom" for the benefit of our new and less-experienced investors. Replies are encouraged, but please keep on topic. Here is Pillar 3.

PILLAR 3. TIME MARCHES ON

Time dramatically enhances capital accumulation as the magic of compounding accelerates. At an annual return of +10%, the total value of the initial $10,000 investment is $108,000, at the end of 25 years, nearly a tenfold increase in value. Give yourself the benefit of all the time you can possibly afford.
----------------------------

Note: Mr. Bogle wrote this in 1994 when 10% was the expected market return. Today, many experts, including Mr. Bogle, believe the expected market return will be somewhat less. That does not change the benefit of time and the power of compounding.

ref: Pillar 2

http://www.diehards.org/forum/viewtopic.php?t=4337

Paul
When times are good, investors tend to forget about risk and focus on opportunity. When times are bad, investors tend to forget about opportunity and focus on risk.

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Compounding

Post by pkcrafter » Mon Jul 30, 2007 11:49 am

No discussion? Is this Pillar now so well known that it is a given?

The power of compounding was nicely demonstrated by poster LH in another thread.
Clearly, starting passive investing with any amount of money, is a smart move especially when young, as one will have many more doubling periods.

2 4 8 16 32 64 128
If there is nothing more to add, we can move to Pillar 4.

Paul
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Post by Ariel » Mon Jul 30, 2007 2:00 pm

Thank you for reminding us all of these important pillars!

One small quibble with this one. Whenever we talk about compounding in an investment context, we should also talk about the countervailing force of inflation, which makes compounding less than meets the eye. :?

In other words, part of compounding is confounded with the confounding effect of inflation :wink:

That makes your point about the possibility of lower returns going forward all the more relevant.

So, whenever possible, we should try to teach new investors about the importance of distinguishing between real and nominal returns. And linking it to the effects of compounding is a good way to proceed.
Do what you will, the capital is at hazard ... - Justice Samuel Putnam (1830), as quoted by John Bogle (1994)

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Post by White Coat Investor » Tue Jul 31, 2007 7:52 am

One other quibble:

We often discuss the fact that we all wished we had started investing at 6 years old to maximize our time to compound. But the truth of the matter is that most people have difficulty investing any significant sum until they are ~30 or so. As kids we don't make much money because we only work part-time or during the summers, in the early 20s (and late 20s/early 30s too for professionals/professional students) we don't have income at all because we're students, and in our late 20s-early 30s we're in that household formation stage where we're buying a larger car, furniture, a larger house, life and disability insurance etc and also are just beginning our careers (hence lower pay than later.)

It really doesn't matter if you have an extra decade or two to compound with if you can only invest a piddly sum.
1) Invest you must 2) Time is your friend 3) Impulse is your enemy | 4) Basic arithmetic works 5) Stick to simplicity 6) Stay the course

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Investing Early

Post by pkcrafter » Tue Jul 31, 2007 9:55 am

EmDoc, I agree with most everything you post, but I have to disagree on your comments about compounding. Here are two quotes and two good reasons from the post "What Not to do While Investing" that illustrate why starting early is wise.

From new investor/poster, NeedWisdom:
If you save $100 when you’re 25, at a growth rate of 10 percent your money will be worth $4,526 when you’re 66. That’s $45.26 for every dollar you save. If you wait until you’re 30, you’ll have $28.10 for every dollar you save. If you wait to age 40, your $1 will grow to only $10.83. Wait until you’re 50? Forget it: $4.18."
And from Travis Morien:
Many people here have commented on how youth brings with it the opportunity to let compounding work its magic.

I agree with that. I'd also add that saving money while young can help instill certain positive habits such as frugality and a savings mentality.

Its true that a $2,000 lump sum when invested in ordinary investments isn't going to amount to a huge amount of money even if you live a long time. What is more important though is establishing the habit of contributing to savings.

If you defer your investing until you are older, its easy to let the years pass. How many people, on reaching some milestone of, say, their 30s, 40s, 50s, 60s or whatever have paused for a moment and wondered where the time went, when did they suddenly get so old, and what have they got to show for it?

A regular savings plan is one proactive way to deal with at least the financial aspects of that.
EMergDoc:
It really doesn't matter if you have an extra decade or two to compound with if you can only invest a piddly sum.
A piddly sum may be in the eyes of the beholder.

Let's say $1000 is invested annually (a piddly $83/month) from the age of 18 to 28. The total with a 9% return would be ~$18,500. With nothing more added, at age 62, that $18,500 would become a not-so-piddly $390,000.

Paul
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Post by psteinx » Tue Jul 31, 2007 10:00 am

Frankly, for most folks, the whole compounding thing is greatly OVERstated.

While equity returns have been quite high for the last ~25 years, that period has coincided with a move from very low (by historical standards) fundamental pricing for equities to very high pricing.

The focus on nominal returns, rather than real returns, exacerbates the problem (as previous posters have noted).

Most experts feel that realistic future returns will be much lower - perhaps 3-5% or so, real.

Taxes take a further bite out of returns.

And there are expenses as well - for the lucky few, the Vanguard investors :), these may only be 0.1-0.3% per year or so, but for the average investor, they will be more like 0.8% or so.

Add it all up, and the after tax real returns for average investors are likely to be <2% or so.

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Re: Investing Early

Post by White Coat Investor » Tue Jul 31, 2007 10:43 am

pkcrafter wrote:EmDoc, I agree with most everything you post, but I have to disagree on your comments about compounding. Here are two quotes and two good reasons from the post "What Not to do While Investing" that illustrate why starting early is wise.

Paul
Paul,

Travis's comments have merit. The importance of acquiring good habits cannot be overstated.

But let's be real about the math aspect of this. I'll use a personal example to illustrate. When I was in college, I made between $4000 and $13000 per summer (usually closer to $4K). If I scrimped and saved and dramatically lowered my standard of living, I could have saved $1000 per year in a Roth IRA from age 18-21. Assuming a 5% REAL, after-tax, after-expense return, at age 65 that money will be worth $36,882.43. After completion of my residency at age 31, it is relatively easy for me to put away $20,000 per year in Roth IRA/401Ks. It hardly lowers my standard of living at all (especially since I've never actually lived on my full salary.) Just ONE year of saving $20,000 at age 31 with that same 5% return and age 65 retirement gives me $105,066.96. Thus my comments above that for compounding to work its magic, there has to be something to compound. Most people in their 20s will get more bang for their buck by buying life/disability insurance, avoiding consumer debt, and saving up a real downpayment than getting on the compounding escalator a few years earlier.

Another illustration. It has been 3 1/2 years since I began investing (defined by me as putting money somewhere besides my bank.) Despite the recent bull market, only 11% of the money in my accounts represents earnings. The rest is just pure, brute saving. And those are nominal figures, I couldn't figure out how to convert them to real figures. Suffice to say that percentage would be a little lower.

I think this idea of high NOMINAL rates of compounding (9-12%) is used by mutual fund salesman to garner high commissions. It makes compound interest sound truly dreamy. The fact of the matter is that most of us only have 2-3 decades (4 at best) worth of compounding before we begin withdrawing. Compounding is important, don't get me wrong, but not quite as magic as most beginning investors believe (especially if they've sat in a mutual fund salesman's office recently.)
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Post by psteinx » Tue Jul 31, 2007 10:57 am

Emergdoc - you bring up an interesting point.

When I was a kid (late 70s, early 80s), my parents would encourage me to save much of the money that came my way - Christmans/birthday money, allowances, money from chores, etc.

I more or less followed their advice/instructions, and had saved perhaps $800 or so by age 14. I don't recall exactly, but it was probably in a passbook savings account, earning ~5.25% at the time.

Yes, I could see that I earned a bit of interest each year, and it was nice. But even as a kid, I was somewhat aware that inflation was eating at that money, too.

But putting aside the issue of whether I knew that I was likely receiving a negative real return on the money, I had also worked out that it was a bit foolish for me to save a high percentage of the relatively limited amount of money that came my way, for use 10+ years down the line, when I knew that in future years, I'd have much higher income.

A kid saving ~25% of (back then) perhaps $500 in annual 'income' sees a serious reduction in kid lifestyle (less baseball cards/comics, etc :) ). But the result of those ~10 years of savings was an amount that I likely surpassed in my first summer of 'real' working as an older teenager. I was able to make ~$100 a week at about age 14 by cutting grass. Never mind my income in my 20s.

I know that kids are taught to save to learn the habit as much as anything else, and I'll probably do the same with my own kids, but still...

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Post by NeedWisdom » Tue Jul 31, 2007 4:12 pm

All of the comments on this thread are at the minimum interesting. Relatively surprised with the negativity. I would suggest that we "be real about the math aspect of this" as well. I would also suggest that we be careful not to paint everyone into a corner based on their own personal experience or situations.

If I want to become a millionaire I have two options. Work hard or hardly work. To me, the latter sounds preferable.

IMHO some of the posters are missing out on one key ingredient. You lose the ability to invest into your 401(k) or IRA (and shelter your money from taxes) after the deadline passes. If I or any 25-year-old contributes $4,000 each year to a Roth until he retires and makes an average annual return of only 8% on his investment, he'll have more than $1.1 million saved by the time he retires at age 65. Taxes, as everyone here is aware, eat away at your returns to a significant degree. If he had invested the money in a taxable account instead, he'd have only $810,000 if his earnings were taxed at 15%. That's more than one-fourth less money than if he'd invested in the Roth. Taxed at 15%. . .

I'll pose a scenario. Situation A: Brent is 25 and invests $4,000/yr or $333/month until he is 35. Then he stops because he gets caught stealing a Snickers bar at Wal*Mart and gets locked up until he turns 65. Situation B: Brent is 25 but reads this thread and decides that he really shouldn't invest because it really just won't make that big of a difference. So he waits until he's 35 and invests $4,000/yr or $333/month from the age of 35 until he turns 65.

Now which Brent is better off, financially speaking, assuming they both achieve the same return rate? Brent A. He would have more money than Brent B. And that assumes that Brent A stops contributing at 35. So, compounding is OVERstated? :lol:

Speaking personally--there are only a few things that I can control in my investing career. I'm not sure what the market returns will be (though some previous posters seemingly have access to these numbers) but I DO know that I'm better off starting now than starting later and I DO know that I'm better off putting even one more dollar into my investments than spending it. Also, most of my friends who are around 25 can invest $4,000 into a Roth. That may not have been the case for EmergDoc but that seems to be my experience. Also, I dare say that not everyone can afford to put away $20,000/yr easily if at all at ANY point in their lives.

The bottom line is I will have over 40 years for the money I invest now to grow before I retire. Though there are many roads to Dublin. . .they all start with a single dollar. To say that it makes no sense to invest a little NOW because you'll have a lot more LATER seems to be a rather shortsighted and unfitting strategy to growing your wealth.
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Post by psteinx » Tue Jul 31, 2007 5:13 pm

NeedWisdom wrote:If I or any 25-year-old contributes $4,000 each year to a Roth until he retires and makes an average annual return of only 8% on his investment, he'll have more than $1.1 million saved by the time he retires at age 65.
Please tell me what investment I should use to achieve an average REAL return of "only 8%" for the next 40 years. I'll make it easier for you by assuming (unrealistically) that expenses are 0%.

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Post by NeedWisdom » Tue Jul 31, 2007 5:35 pm

psteinx wrote:
NeedWisdom wrote:If I or any 25-year-old contributes $4,000 each year to a Roth until he retires and makes an average annual return of only 8% on his investment, he'll have more than $1.1 million saved by the time he retires at age 65.
Please tell me what investment I should use to achieve an average REAL return of "only 8%" for the next 40 years. I'll make it easier for you by assuming (unrealistically) that expenses are 0%.
Buy ORCL. It will return an annualized 14%. Guaranteed! *End sarcasm*

As usual my crystal ball is a bit cloudy, but considering that I (nor you btw) can know what inflation or returns of any asset class will be, there is no answer. And it doesn't say REAL returns. It was an example not including inflation.

Brent A still comes out with more money than Brent B. That's the point.

I'd rather have $1.1 million than not, regardless of inflation.
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Post by White Coat Investor » Tue Jul 31, 2007 7:45 pm

NeedWisdom wrote:And it doesn't say REAL returns. It was an example not including inflation.

Brent A still comes out with more money than Brent B. That's the point.

I'd rather have $1.1 million than not, regardless of inflation.
That's just my point. No one ever includes inflation. If you simply use inflation adjusted numbers in your example the results are quite different. All we have to do is change 8% to 5% to adjust for 3% inflation (all assumptions of course.)

Now Brent A ends up with $217,443 and Brent B ends up with $265,775.

It isn't necessarily all about compounding when the real rates we compound at are so low. That is why keeping expenses (and taxes) low is so important, even increasing the compounding rate from 4.5% to 5% makes a dramatic difference.

The intent of my post above wasn't to talk anyone out of saving while young, just to help them realize it isn't going to make as much of a difference as many authors and ALL mutual fund salesmen would have you believe. That just means they actually need to save MORE to reach their goals.

But there is a point for all of us where the investment returns are so bleak it is preferable to spend the money on consumption now. Is it a real return of 1%, 2%, 3%? Who knows, it is probably different for all of us. But I can tell you what, if I expected 1% real returns from my portfolio in the future I would be spending more now and plan to work longer.
NeedWisdom wrote: I'd rather have $1.1 million than not, regardless of inflation.
If inflation is 10% a year for the next 10 years that million will be very easy to come by. If you bought $350,000 worth of a 10 year TIPS today at 2.5% real, you would have $1.1 Million in 10 years. Of course it would only be worth $450,000 in today's dollars.
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Post by NeedWisdom » Tue Jul 31, 2007 8:12 pm

EmergDoc wrote:
NeedWisdom wrote:And it doesn't say REAL returns. It was an example not including inflation.

Brent A still comes out with more money than Brent B. That's the point.

I'd rather have $1.1 million than not, regardless of inflation.
That's just my point. No one ever includes inflation. If you simply use inflation adjusted numbers in your example the results are quite different. All we have to do is change 8% to 5% to adjust for 3% inflation (all assumptions of course.)

Now Brent A ends up with $217,443 and Brent B ends up with $265,775.
While still contributing only 1/3 the amount of time and 1/3 the amount of money! While I see your point, looking at those numbers still shows the picture I was attempting to portray. Starting earlier yields big dividends.

That's "it". That's my point. And I'll argue it until I die.
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Compounding

Post by pkcrafter » Tue Jul 31, 2007 8:16 pm

Thanks for the additional replies.

Doc, while I can appreciate your path and your circumstances, I don't think you can be considered a typical profile of the average investor.

As for the comments about real vs nominal returns or what future returns might be, I can't see how this relates to starting early and the effects of compounding. You can compound what you are given.

psteinx, the power of compounding can be demonstrated with either real or nominal returns. NeedWisdom used nominal returns of 8%, which I think is quite reasonable.

And it seems that some of the comments are really about the futility of saving at an early age rather than spending. I think it is rather simple. Either you start out early and take advantage of the compounding effect or you begin saving/investing later and you don't.

Thanks to all again,

Paul
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Post by White Coat Investor » Tue Jul 31, 2007 9:54 pm

NeedWisdom wrote:
That's "it". That's my point. And I'll argue it until I die.
I agree. I was only pointing out that the effect isn't as large as many believe it to be, not that the effect of compounding isn't real, nor that it isn't a very important part of investing. It certainly deserves to be a "pillar," whether it compounds at 5% (as is more likely) or at 12% (as we all hope and mutual fund salesman display.)

An additional consideration takes a hypothetical young person at age 18. He has the option at age 18 to go to college and law school and make $100,000 per year starting at age 28 or begin working "down at the plant" for $50,000 per year starting now. Assuming he saves 10% of what he makes in either job from day 1 until he FIREs at age 50, the compounding rate makes a huge difference. If he compounds at 5%, he is better off going to law school. If he compounds at 10%, he is better off at the plant.

5% Compounding= $376K as plant worker and $385K as lawyer
10% Compounding=$1,006,000 as plant worker and $714K as lawyer

It really does make a difference as to whether you use real or nominal returns when making some decisions. An understanding of the drag of inflation, taxes, and expenses is critical to the success of an investing plan. It also really does make a difference as to whether you are using an accurate figure when you project your future returns as part of your lifetime financial plan.

But I think we all agree that compounding is good and that without at least some compounding, none of us will ever reach our financial goals. If there were no such thing as compound interest I doubt I could retire before age 75, no matter how much I save.

Like my signature says, "Time is your friend."
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Post by jh » Tue Jul 31, 2007 10:21 pm

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Post by White Coat Investor » Tue Jul 31, 2007 10:28 pm

jh wrote:If your return is coming in the form of unrealized capital gains, is it really compounding at all?

The way I see it, you can't compound a gain until it is taken off the table and reinvested first.
Sounds like a screwy argument for dividend investing. The effects of paying dividends on management aside, it doesn't really matter whether you reinvest it or the company you own (by virtue of holding its stock) reinvests it for you. Surely you don't believe Berkshire Hathaway's shareholders aren't benefitting from compound interest just because they've never been paid a dividend.
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Post by jh » Tue Jul 31, 2007 10:34 pm

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Post by psteinx » Wed Aug 01, 2007 10:49 am

To those who play down the significance of nominal vs. real returns:

It seems rather foolish to ignore this. When you're looking 20-40 years in the future, it is very hard to make simple adjustments between nominal and real sums. There is a tremendous difference between $1 million 40 years from now, in today's dollars, and in the devalued currency we will likely have by then. No, I'm not an inflation hawk, but even at 3% annually, $1 million nominal in 40 years is about $306,000 today. And there's a big difference between $1 million and $306,000.

As for (real) rates of return, those are important too.

If I have the option to invest $4,000 per year at a real return of -5%, I will probably decline. At a real return of +10%, I will almost certainly accept. Unfortunately, both of those numbers are probably bogus, but finding the appropriate number to use will affect the attractiveness of the option. FWIW, I believe I've often seen numbers in the 10% range used for future returns calculations. Of course, those are generally nominal numbers, but again, folks are easily confused by the difference between real and nominal numbers.

Anyways, if real returns are only, say, 2% (still low, in my opinion, but not ridiculous), then for many folks, saving at high rates while relatively young (say, under 40), is probably not desireable. Considering that most folks' income grows at >2%, real through age 40 and perhaps beyond, it will likely be easier for them to save a chunk of their salary when they're a bit older, with a larger salary, but with less early-life costs (first house, first cars, student debt and so on).

NeedWisdom, you say I don't have a crystal ball, which is true, but neither do you, but even though neither of us have such a device, we still need a rough estimate of future returns in order to make reasonable plans for the future. You were quite content to throw out a figure of 8%, so I'm assuming that you're very willing to make such predictions, despite your criticism of me for making a prediction. You didn't specify nominal or real, but most folks on this forum, when talking about future returns, make estimates in real terms, so that's what I assumed for your figure. In your defense, the first post mentioned a 10% figure that was apparently nominal as well.

In any case, if we translate 8% nominal to 5-5.5% real, I still think that's a bit high for future returns, at least in the foreseeable (10-20 years) future. Beyond that is a bit too far out for even my crystal ball :).

At either 4% (my figure) or 5-5.5% (yours), the case for saving from an early age is, IMO, attractive, but not totally compelling. If a 25 year old focuses his/her spending on more immediate needs, knowing that his/her income is likely to rise significantly in later years, I hardly think that they're making an obvious mistake.

(And I say that as someone who saved a high proportion of my income in my early 20s, even though I expected my income to rise quite a bit).

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