Commentary: Life by a thousand small cuts
March 01, 2014
The following commentary was written by Vanguard senior investment analyst Don Bennyhoff.
You've heard the phrase "death by a thousand cuts." Maybe I'm a "glass half full" kind of person (I really do think every cloud has a silver lining if you're willing to look for it), but I'd prefer to put an optimistic twist on that cliché: life by a thousand cuts—cuts in spending, that is.
Too often, the idea of saving more (or spending less, depending on your disposition) has a negative connotation: To save or invest for the future, you must forego spending money today. But this perspective ignores an important point that might have even been lost on Ben Franklin; a penny saved can equal a lot more than a penny earned.
Costs matter, and investors are getting the message
When investors evaluate a mutual fund, how much do costs matter to them? Fees and expenses are frequently mentioned considerations, but are investors actually walking the talk?
Given time and even a modest return, small savings can really add up. For example, if I skipped a few impulse purchases at the checkout line, turned down the heat (or turned up the AC) a little, or brought lunch to work a few days each month instead of eating out, how much could I save—$50 a month? $100? More?
Let's look at a hypothetical example. Assume you save $100 a month by trimming expenses here and there. Also assume that you earn a modest 4% real (inflation-adjusted) return on the money you save. A year later, you've earned $26 on top of the $1,200 you saved. After 10 years, that $26 has grown and compounded to $2,718. After 30 years, it's worth $32,751.
Now, you may be thinking that $32,751 might not be worth 30 years of brown-bag lunches—and to a point, you might be right. But if you ended up needing that money in the future, I doubt you'd regret all those homemade lunches and other foregone purchases. Of course, for some people, saving an extra $100 a month would require major sacrifices. For many others, however, such a goal is well within reach. The point is to start somewhere, and save as much as you can reasonably afford. We all probably have a lot of areas where we can reduce expenses, allowing our savings assumptions to be magnified.
So far, we've talked about returns, rather than overall growth in wealth. In our $100-a-month example, the total portfolio, including savings plus net earnings, could be worth $68,751 after 30 years. That's a lot of extra wealth to provide for future spending needs—just by saving a bit of money on purchases you could do without.
And while returns are out of investors' control, saving diligently and controlling costs aren't. Sound familiar? For Vanguard, this message is central to both our investment philosophy and our company's DNA.
In January, we announced that U.S. investors have more than $2 trillion invested with us. That's more than 15% all of the money invested in the U.S. mutual fund industry (source: Strategic Insight, as of December 31, 2012). We believe our focus on controlling costs has a lot to do with Vanguard's success. After all, the asset-weighted average expense ratio for our funds is about 15 basis points (that is, $15 for every $10,000 invested), compared to about 65 basis points for the industry (source: Lipper Inc., as of December 31, 2012). This represents an annual savings of about $10 billion compared with the industry average, according to our calculations.
If even a small portion of investors in higher-cost funds were to move to lower-cost funds like Vanguard's, the "wealth effect"—even when compounded at very modest rates—could be quite significant. (The good news, from our perspective, is that mutual fund industry cash flows do show a movement from higher-cost to lower-cost funds. See our newly updated research paper Costs matter: Are fund investors still voting with their feet?)
A powerful partnership
Investing is a partnership between investors and the markets, with investors providing the capital and the markets providing the return. Unless you're expecting a Powerball-like payoff, you need to make a significant commitment to saving. Too often, though, people focus more on the return aspect, which is largely out of their control. They attempt to leverage meager capital contributions into much greater wealth by pursuing higher-risk, higher-return strategies, only to realize too late that these strategies can actually reduce wealth, sometimes dramatically.
If you want your portfolio to be worth more next year than this year, a more certain means of achieving that goal is through your role in the partnership—your capital contributions—rather than the markets' return. After all, if you invest $1,000 this year but the investment loses 10%, you're still better off by $900 than if you hadn't invested any money at all. Again, the focus should be on wealth creation, not return on capital alone.
Tying it all together
While most people know that they need to save more for retirement, they tend to save less than they should. According to Vanguard research, the median contribution level in 2010 in 401(k) plans administered by Vanguard was just 6% of income—far short of the 12% to 15% savings rate Vanguard recommends.
The chart below shows three savings scenarios for a hypothetical investor with a $50,000 annual income whose investments receive a 4% real return:
|Wealth created after 1 year:||$3,065||$6,129||$7,662|
|Wealth created after 5 years:||$16,599||$33,198||$41,497|
|Wealth created after 10 years:||$36,794||$73,588||$91,985|
|Wealth created after 30 years:||$171,878||$343,757||$429,696|
|Saved per month:||$250||$500||$625|
|Saved per day*:||$8.33||$16.67||$20.83|
* Assumes an average of 30 days each month.
Source: Vanguard. These examples are hypothetical and do not represent the return on any particular investment.
Granted, for some people a monthly commitment of $500 or $625, as shown above, would be too onerous. That said, I'd argue that the difference between a 6% savings rate and those higher contribution levels is worth the potential benefit, and that it may not be as much of a stretch as it seems at first glance. For this hypothetical investor, moving from 6% to 12% requires an additional savings of a little more than $8 per day, while a 15% contribution requires saving less than $13 more per day. Over time, those higher savings levels could add up to hundreds of thousands of dollars in additional assets.
When the topic of saving money arises, it seems like people think about big-ticket items first. And while the potential impact of deferring the purchase (or paying less for the purchase) of, say, a car is greater than a cup of coffee, we shouldn't ignore any part of our spending—large or small. In this way, a better life and greater wealth can be the result of a thousand small cuts.
I'd like to thank my Vanguard Investment Strategy Group colleague Yan Zilbering for contributing to this commentary.
- All investments are subject to risk, including the possible loss of the money you invest.
- Past performance is no guarantee of future results.
- The hypothetical examples in this commentary do not represent the return on any particular investment.