Your Complete Guide to Index Investing with Dan Bortolotti

Some Advice for New Potatoes

2014-10-03T08:01:12+00:00March 5th, 2012|Categories: Indexing Basics|77 Comments

One of the most gratifying things about writing this blog is getting emails from young people who are just getting started in Couch Potato investing. “Without you,” a 23-year-old wrote this week, “who knows what I would have continued to do with my money.” I wish I could say I got started that young.

New Potatoes are often full of questions about the ideal asset allocation (“Should I include 10% in emerging markets?”) and how they might save a few basis points by choosing Vanguard ETFs instead of the TD e-Series funds. But when it comes to new investors who are starting small, I think these decisions are almost immaterial.

If I could send one message to young people who are just beginning their investing journey, it would be this: stop worrying about squeezing out incrementally higher returns and concentrate on saving more money. Because when your portfolio is small, the size of your monthly contributions has a much a greater effect than your rate of return.

When savings are more important than costs

To illustrate this idea, let’s look at two investors at different stages of life. Christopher is in his early 20s and has just started his first full-time job. He’s saved $5,000 in his RRSP and plans to sock away another $100 a month. Christopher is trying to determine the perfect asset mix and keep his fees as low as possible. But what if instead of trying to optimize his portfolio he instead made an effort to increase his monthly contribution to $150, or even $200?

Starting value $5,000, contributions for 10 years
Rate of return $100/month $150/month $200/month
1.5% $18,151 $24,464 $31,717
2% $19,400 $26,047 $32,694
3% $20,756 $27,760 $34,765
4% $22,228 $29,615 $37,002
5% $23,828 $31,624 $39,421
6% $25,567 $33,802 $42,037
7% $27,458 $36,162 $44,867
8% $29,515 $38,723 $47,931
9% $31,753 $41,502 $51,250

As you can see in the table, at $100 a month and a rip-roaring annual return of 9%, Christopher would have $31,753 after 10 years. But if he increased his contribution by 50% to $150 a month, he would only have to earn 5% to wind up with the same amount. If he were able to dig deep and double his monthly contribution to $200, he wouldn’t even have to take any market risk: a savings account earning just 1.5% would leave him with an almost identical $31,717.

It seems clear that at this stage of his investing career, Christopher is far better off finding an extra $50 to $100 in his budget rather than trying to get an extra percentage point out of his portfolio’s performance—let alone 10 or 20 basis points by choosing ETFs instead of index mutual funds.

When low costs are paramount

Now let’s consider Nicole, who is in her 50s and has accumulated $200,000. Nicole is well along in her career and is now contributing $500 a month to her account. She wants to get an extra 1% out of her portfolio to ensure that she retires with a comfortable nest egg, and she is considering making some changes that will lower her costs by that amount. She wants to compare this cost savings to the alternative of raising her monthly contribution to $750, or even $1,000:

Starting value $200,000, contributions for 10 years
Rate of return $500/month $750/month $1,000/month
4% $372,036 $408,972 $455,907
5% $407,367 $446,349 $485,331
6% $446,229 $487,403 $528,578
7% $488,980 $532,503 $576,027
8% $536,011 $582,052 $628,093

Because Nicole’s portfolio is so much larger than Christopher’s, lower costs (or higher investment returns) now mean thousands of dollars every year. Increasing her returns by one percentage point over 10 years would have a greater effect than increasing her monthly contribution by 50%. And two percentage points—the approximate MER difference between a typical portfolio of actively managed mutual funds and ETFs—accomplishes more than doubling her contribution. It adds up to about $100,000 over 10 years.

Keeping costs low and choosing an appropriate target rate of return are important at every age. But the truth is, if you’re a young investor these factors matter a lot less than you think. In your 20s, it’s better to focus on spending less than you make and saving the difference. Once you have built significant wealth—and you will—then those basis points become much more important. Lay a foundation of good habits and by the time you enter your peak earning years you’ll be primed for success.