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he retired with a sum that was more than 26 times his final annual salary of $38,004, which, by the way, didn’t come close to keeping up with infla- tion over the period. Thank goodness he was a consistent investor. Note that Joe achieved these results while investing in a balanced portfolio—it was the power of compounding that drove the results, not excessive risk taking. The first chart to the right shows the percentage breakdown between contri- butions and investment returns in Joe’s portfolio at various milestones. In the earlier part of his investing career, Joe’s monthly contributions accounted for the majority of the assets—this was the case even after 10 years. By

Contribution vs. Returns

Discipline and Patience Lead to Growth

Contributions

Investment Returns

0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

$1,000,000

Contributions Return on Contributions Return from Compounding Account Value

$800,000

$600,000

$400,000

% of Portfolio

$200,000

$0

30 35 40 45 50 55

60

65

Age

6/74

6/79

6/84

6/89

6/94

6/99

6/04

6/09

6/14

around the age of 40, after 15 years of monthly investments, Joe’s port- folio had reached its tipping point, and from then on out, compounding

returns increasingly pushed the value upward as his contributions became proportionately smaller parts of the whole. Keep in mind that Joe’s account weathered all types of markets. Joe was in his 30s when stocks dropped over 20% in single day on October 19, 1987. Joe invested through the steep market declines of the tech bubble in the early 2000s while in his early 50s and the financial crisis of 2008–2009 when he was in his late 50s. During those periods, his account experienced draw- downs of 23.4%, 14.8% and 32.0%, respectively—this is where Joe’s selec- tion of Wellington, which holds both stocks and bonds, helped reduce the full drawdown experienced by stocks. The second chart above shows that by the time the tech bubble burst and the financial crisis hit, Joe’s account had already hit the turning point where compounding had taken over. As a result he quickly regained and sur- passed what was lost, helped by the strong stock market returns off of those bottoms. The lessons for a young investor are clear: Start early, pick a plan and stick to it, and let compounding and time work in your favor. If you are a more seasoned investor, when it may feel like every market surge and correction is going to make or break your portfolio, think of these compounding tipping points, what it takes to get there and how impressive the results can be. Over time, the impact of compounding will more than make up for the inevitable potholes on the road to wealth. n

Let Taxes Encourage Better Behavior ONE KEY COST THAT I AVOIDED in our discussion on compounding was taxes. But for many inves- tors, taxes are a real cost: In a taxable account, when you sell a stock or bond or ETF or mutual fund, you owe taxes on any profits. Those taxes on trades are a headwind against compounding. Let’s walk through an example. Say you made a $1,000 investment, buying 100 shares in a fund with a $10.00 NAV. The fund’s NAV subsequently rises to $15.00, and your investment has grown to $1,500, giving you an unrealized gain of $500, or 50%. You decide to sell—realizing that $500 gain. At a 30% tax rate, you owe $150 in taxes. This leaves you with $1,350 in cash. You now have less money—10% less, to be specific—to compound upon. So if you sold to avoid a potential decline in the markets, your decision won’t have been a prof- itable one unless the markets fall 10% (at a minimum). Otherwise, you would have been better off staying in your original holding. Of course, a 10% decline is not a magic number—the decline you need to break even after paying taxes varies depending on your tax rate and the level of gains being realized. In the table below, I’ve done the math for you to determine how steep a decline in the markets (or your investments) you would need to see to justify selling your shares in order to side-step a market decline.

Market Drop Required to Justify Selling Now

———————————— Taxable Unrealized Gains ———————————— 5% 10% 15% 20% 25% 50% 75% 100% -0.5% -0.9% -1.3% -1.7% -2.0% -3.3% -4.3% -5.0% -0.7% -1.4% -2.0% -2.5% -3.0% -5.0% -6.4% -7.5% -1.0% -1.8% -2.6% -3.3% -4.0% -6.7% -8.6% -10.0% -1.2% -2.3% -3.3% -4.2% -5.0% -8.3% -10.7% -12.5% -1.4% -2.7% -3.9% -5.0% -6.0% -10.0% -12.9% -15.0% -1.7% -3.2% -4.6% -5.8% -7.0% -11.7% -15.0% -17.5% -1.9% -3.6% -5.2% -6.7% -8.0% -13.3% -17.1% -20.0%

Tax Rate

10% 15% 20% 25% 30% 35% 40%

Market timing is difficult. You have to get the timing of the decline right, you have to sell before it happens, and then you have to figure out when to get back in. A market timer subject to taxes also has to be confident the magnitude of the losses is enough to offset the taxes incurred in selling to avoid those losses. Most investors—no, probably all investors—are going to be bet- ter off avoiding the taxes and letting compounding work for them over time. In short, taxes are yet another reason why it doesn’t pay to try to time the market.

The Independent Adviser for Vanguard Investors • September 2014 • 13

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