The “tyranny of compounding costs” is hardly a headline anyone wants to read. Yet people truly need to understand what Vanguard Founder John Bogle means when he says that cost is the major driver in how long-term retirement investing turns out.
Most people assume that picking the investments matters. And in a sense it does. If you put all of your money into ultra low-interest bank CDs it will be safe — but it won’t grow much. Play around with microcap stocks and you might as well be tossing your cash out a car window.
That’s why people mostly buy shares in large and well-understood companies. They try to choose some stocks over others, but really it’s just owning stocks that matters. Stocks remain the most powerful retirement investment you can make.
That’s because when you own a broad selection of stocks, buy more periodically and reinvest the dividends, you increase your ownership in the for-profit enterprise known as the global economy.
People also assume, rightly, that time matters. If you figure that stocks will increase in value by some amount year after year, the longer you own them the more likely it is that you will partake in the kind of growth that turns small, periodic investments into enough money to retire.
What remains is the cost of investment. As it turns out, cost is the principal reason some people do better (or worse) at investing than others. Pay too much for your investments and you will lose a lot of money.
How much worse? How about two-thirds of your gains! It sounds crazy until you recognize what happens when supposedly small fees are allowed to run on for decades — Bogle’s tyranny of compounding costs.
“Let’s assume the stock market gives a 7% return over 50 years. If you get to 7%, each $1 goes up to $30. If you get to 5% (that would be 7% less the industry’s typical 2% all-in costs), you get $10,” Bogle recently said in an interview.
“So $10 versus $30. You put up 100% of the capital, you took 100% of the risk, and you got 33% of the return! As I say to people, if that strikes you as a good deal, by all means do it!”
Deciding which stocks are better, the basic due diligence, is meaningless at the level of the entire stock market. Even people whose full-time job is to make these determinations get it wrong all the time.
Yet broadly owning each investment type — stocks, bonds, and so on — does provide a generally predictable long-term return. Owning a mix of them in a portfolio and doing it cheaply via index funds gives you a good return plus low investment costs.
That’s how you avoid Bogle’s tyranny of compounding costs, and how you keep your investment results in line with the risk you assume in investing at all.
Why sign on for a two-thirds guaranteed loss and only a one-third of the reward? It’s your retirement at risk, after all.