John C. Bogle – his nickname is Jack – is an investing legend… he founded The Vanguard Group in 1975, created the first ever Index Fund and has grown Vanguard into one of the largest asset managers in the world – Vanguard now manages over $2 trillion, that’s phenomenal!
The Magic of Compounding
Bogle recently wrote a guest article for CNBC titled “Jack Bogle’s advice for a rocky market: Follow Ben Franklin”… and I though this article was very timely because we’ve already had a rough start to the year with the Dow down about 4.5% in January and high volatility in the first week of February… and research shows that January performance often sets the tone for the rest of the year… so let’s see what Bogle’s advice is for a potentially rocky 2014… it’s actually pretty simple and easy to implement.
Bogle invokes Benjamin Franklin and extols his investment wisdom… that simplicity trumps complexity in the stock market. And Bogle begins with what he calls Franklin’s acute understanding of the miracle of compound interest. In 1794, Franklin bequeathed a thousand dollars each to his native city of Boston and his adopted city of Philadelphia, to be kept in an interest bearing account over a period of 200 years… good ol’ Ben assumed a 5% average annual rate of interest and surmised that the $1,000 would grow to about $17.3 million in 200 years. In reality, due to various financial and legal reasons, Boston’s fund grew to about $5 million by 1994 while Philadelphia’s fund grew to less than half that amount – $2.25 million. And even though these amounts underperformed dear Ben’s calculations, they still handsomely showed the explosive mix of rate of return and time… the magic of compounding!
The Tyranny of Compounding Costs
But, of course, 200 years is impractical for most of us saving for retirement, so Bogle focuses on a 65-year time horizon that assumes a 45-year working career from ages 20 to 65, and 20 years in retirement… and says $1,000 invested at age 20, compounded at about an 8% average annual rate of return, could grow to almost $150,000 through simple compounding… but before we get our hopes up, Bogle hastens to add that in reality, fees and commissions would eat up about 2.5%… and reduce your actual rate of return to about 5.5%… so that $1,000 will grow to only about $32,500 – not $150,000 – that’s a whopping 80% reduction in wealth accumulation because of what Bogle calls the tyranny of compounding costs that significantly overcome the magic of compounding.
So while many investors take fees and expenses in stride, they do not realize that the reduction in effective annual rates of return take a really huge bite out of their total investment gains.
Think of it this way – you put up all the capital, but money managers, marketers of investment products and stockbrokers – who put up zero capital and assumer zero percent risk – receive fully 80% of the return… a shift from owners’ capitalism to managers’ capitalism that devastated investor returns.
So the way to build wealth is to avoid the high cost, high turnover tactics that characterize our financial system… and, instead, to rely more on the magic of compounding… perhaps through low-cost index funds… and, Bogle says, while the interests of a business are served by the saying “Don’t just stand there. Do something!”, the interests of an investor are served by the exact opposite… “Don’t do something. Just stand there!” and let time do its magic.
“the way to build wealth is to avoid high cost, high turnover tactics”