The Independent Adviser for Vanguard Investors
•
September 2014
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13
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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
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
Contribution vs. Returns
% of Portfolio
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
Age
Contributions
Investment Returns
30 35 40 45 50 55
65
60
$0
$200,000
$400,000
$600,000
$800,000
$1,000,000
Discipline and Patience
Lead to Growth
6/74
6/79
6/84
6/89
6/94
6/99
6/04
6/09
6/14
Contributions
Return on Contributions
Return from Compounding
Account Value
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 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.
Market Drop Required to Justify Selling Now
———————————— Taxable Unrealized Gains ————————————
Tax Rate
5% 10% 15% 20% 25% 50% 75% 100%
10%
-0.5% -0.9% -1.3% -1.7% -2.0% -3.3% -4.3% -5.0%
15%
-0.7% -1.4% -2.0% -2.5% -3.0% -5.0% -6.4% -7.5%
20%
-1.0% -1.8% -2.6% -3.3% -4.0% -6.7% -8.6% -10.0%
25%
-1.2% -2.3% -3.3% -4.2% -5.0% -8.3% -10.7% -12.5%
30%
-1.4% -2.7% -3.9% -5.0% -6.0% -10.0% -12.9% -15.0%
35%
-1.7% -3.2% -4.6% -5.8% -7.0% -11.7% -15.0% -17.5%
40%
-1.9% -3.6% -5.2% -6.7% -8.0% -13.3% -17.1% -20.0%
