While compounding does great things for investors' returns, it does terrible things for their costs, says Jack Bogle, founder of The Vanguard Group.
In a column he wrote for
CNBC, Bogle borrows an example of compounding from his book "The Battle for the Soul of Capitalism." He uses a 65-year time horizon for the investment. If $1,000 was invested for that period, earning the historical stock market return of 8 percent, you would have $148,780 at the end —"the magic of compounding returns," Bogle noted.
"But I quickly warned that this total was unlikely to be achieved. Why? Because the obvious magic-of-compounding returns was all too likely to be overwhelmed by the subtle tyranny of compounding costs."
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How does this work?
"Assuming an annual intermediation cost (by mutual fund managers) of only 2.5 percent, the 8 percent return would be reduced to 5.5 percent," Bogle wrote in his book. That means your $1,000 would turn into only $32,465 — "the tyranny of compounding costs," he wrote.
"The triumph of tyranny over magic, then, is reflected in a stunning reduction of almost 80 percent in accumulated wealth for the investor . . . consumed . . . by our financial system."
Money managers, investment product marketers and stockbrokers put up zero percent of the capital and take zero percent of the risk but receive 80 percent of the return, Bogle explained. "Something has gone terribly wrong in our financial system. . . . The shift in our system from owners' capitalism to managers' capitalism has been devastating to investors."
So what should investors do? Bogle recommends more passive investing.
"The way to wealth, it turns out, is to avoid the high-cost, high-turnover, opportunistic marketing modalities that characterize today's financial service system and rely on the magic of compounding returns," he stated.
"While the interests of the business are served by the aphorism, 'Don't just stand there. Do something,' the interests of investors are served by an approach that is its diametrical opposite: 'Don't do something. Just stand there!'"
U.S. investors apparently are getting the message. They put a record $115 billion into index mutual funds last year, far surpassing the $38.3 billion they put in actively managed mutual funds, according to the Investment Company Institute.
Dan Solin, a wealth adviser at Buckingham Asset Management, offered five tips for investing in index funds in
U.S. News & World Report.
1. Pay attention to costs. Fees for index funds can vary widely, he says.
2. Choose diversified funds.
3. Stay away from leveraged funds.
4. Avoid specialized funds.
5. Remember discipline. Aside from regular rebalancing, stick to a buy-and-hold philosophy, Solin noted.
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