It’s not just “time in the market,” it’s how much you deposit.
This is a story of incredible wealth generation and how many investors are missing out on it.
It started with a recent column in which the math wasn’t working for Steve K. in Seattle.
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The column discussed Ed Owens, the retiring manager of the Vanguard Health Care fund; both the manager and his fund had the top track record of any fund that was around when the market crashed in 1987 and that survives today. Steve actually bought into the fund in 1986, shortly after it opened.
What Steve couldn’t fathom, however, was why his results weren’t nearly what the column suggested they should be.
Vanguard Health Care had turned a $10,000 investment into about $310,000 in the last two-and-a-half decades, but his portfolio had grown to just over half of that. While he started with less than $10,000, Steve figured he had crossed that threshold in 1990; all dividends and capital gains had been reinvested and he had never withdrawn a cent.
A Vanguard representative told Steve that investment data before 1993 had been purged (that is very common with older accounts; firms were not required to maintain transaction records, and many did not). No one from the company could say why Steve’s returns were so far off from what the fund had achieved.
Was it simply unfortunate timing? Was it the lower-than-$10,000 starting point? Was it that he didn’t make IRA contributions to the account every year? Was it bad record-keeping, bad math by the columnist or something more nefarious?
“Sure there were differences from the $10,000 all being invested in 1987, but to have that be the difference between roughly $300,000 I thought I should have — based on the returns shown in the article — and the $160,000 in my account didn’t make sense,” Steve said.
Alas, the difference was completely logical, and it showcases one of the biggest blunders investors make, because it is a lesson in the magical power of compounding.
Steve thought he opened the account with several thousand dollars, but further reflection showed it was $1,000; he split the maximum allowable contribution to an individual retirement accounts at the time between Vanguard Health Care and another fund. Even with a second contribution in 1987 and some solid growth by the fund, he was less than halfway to the $10,000 example starting point when the ’87 market crash occurred.
While his continuing contributions helped him play catch-up, the lower starting point effectively cost him one “double,” or the period of time it would take for his account to double in size.
Start with the Rule of 72 (take 72, divide it by the rate of return and you will see how long it takes for an investment to double) and an annualized return of 14.5 percent — about the fund’s performance for the last 25 years — and you see that an account would double in size every five years.
Thus, in 25 years, an investor gets five doubles, turning $10,000 into $20,000, then $40,000, $80,000, $160,000 and on up to roughly $320,000.
If Steve started the same period with roughly $5,000 on account, his five doubles leave him with roughly half the cash at the end.
There’s no “missing” money; he never deposited some of it, so he didn’t earn the rest of it.
“It seems like such a small difference, but when you see how big that difference is at the end, it really makes me wish I had found a way to do more when I was younger,” Steve said.
There’s an investing adage about how “it’s not about timing the market, but about time in the market.” Ironically, Steve did both well; he bought the best fund of his generation, gave his money to the best manager of a generation and let it ride.
Perfect timing and plenty of time, just not enough cash.
During the Internet bubble days, investors got used to double-digit returns and basically expected the market to save for them, putting fewer dollars to work planning on the market making up the difference.
Today, Roger Ibbotson of Zebra Capital Management — whose market-history studies of the past convinced most people that stocks should return 10 percent per year — says the next 25 years will feature returns closer to 7 or 8 percent. Slower growth coupled with lower deposits is a recipe for starting small and staying that way.
The market slows down the pace of the doubles; lower deposits exacerbate the problem.
At a time when the market has many investors scared enough to be on the sidelines or looking for the exit or considering how they might benefit from avoiding the next downturn, the market’s less-rosy long-term outlook should instead be pushing them into investments that will capture the market’s trend for the next 25 years and beyond, making the most of the market’s compounding power.
“People forget that it’s not just the market or the funds that plays a role,” Ibbotson said, “it’s what the investor does themselves, whether it’s staying invested for so long, or putting in enough money to let time and the market grow it into something big.”
Chuck Jaffe is senior columnist for MarketWatch. He can be reached at firstname.lastname@example.org or at P.O. Box 70, Cohasset, MA 02025-0070.
Copyright, 2012, MarketWatch