How To Increase Your Retirement Savings Like an Economist
This post was inspired by a number of e-mails from Fidelity and Schwab, where I hold my investment accounts, proposing investment strategies for retirement. Since a large portion of the advice that investment managers give ranges from unnecessarily costly to nonsense, I decided it was time to bring some actual empirical evidence into my previous discussions of investing.
Regardless on your particular views on how efficient the stock market is and whether it is in theory possible for well-informed investors to beat the market, pretty much every academic economist I know of who studies the issue believes that it is mistake for the average investor to invest actively.
Active investment can take two forms:
1) Selecting stocks and making your own portfolio
2) Investing in mutual funds where you pay a manager to use his “stock picking talent” to attempt to earn above-market returns
The alternative to this strategy is to buy index funds which I’ve discussed at length in previous posts and can be viewed if you scroll down to the categories list at the bottom of this page and click on finance.
This paper by the eminent financial economist Ken French actually quantifies that average cost of active investing for the average investor:
French calculates that the average investor would increase their returns by 0.76% per year by changing from an active investing strategy to a passive one. Now at this point you might say 0.76% per year doesn’t sound like very much, why bother?
Well the answer is that because of the magic of compound interest, this actually works out to be a substantial difference over a lifetime of investing. I’ll illustrate with an example:
Say you invest $10,000 for 30 years. Assume the interest compounds continuously.
In case one assume that your return is 7.00% per year. In case two your return is 7.76% per year.
Then in case one at the end of thirty years you would end up with approximately $81,140.
In case two you would end up with $101,148.
Thus the difference is almost $20,000! And of course many of you will invest far more than $10,000 over the course of your lifetime.
Say now that you invest $250,000 over 30 years.
Then in case one you would end up with $2,028,502.
In case two you would end up with $2,546,200.
Now the difference is over $500,000! That sort of additional money could really come in handy come retirement time.