The One Percent Difference

The One Percent Difference

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Results matter. In the age of fee compression, investors continue to invest in low-cost, passive index funds and hope for the best. And who can blame them, as so-called financial “experts” continue to tout that, while the stock market “has no science to it,” the one thing they can control is fees. To an extent, they are right, as fees are directly set by investment firms. However, to advise individuals to simply invest in the cheapest funds and cross your fingers because “there is no science to the stock market” is not only irresponsible but can also have long-lasting impacts on their financial futures.

A prevalent obstacle to the average investor is not having any context for their returns. A 2017 Dalbar study titled Quantitative Analysis of Investment Behavior found that the average investor underperformed the market by 4.7%, earning 7.26% versus the market’s return of 11.96%. Now, most investors wouldn’t flinch at a return of 7.26%; it means their investments are growing and beating inflation. However, leaving even one percent return on the table can affect your retirement plans.

The study

In “Results Matter: Even a Small Increase in Returns Can Dramatically Improve Outcomes,” an American Funds analysis from May 2017, a hypothetical scenario using Capital Group as its source was created to discover what the effect of gaining an additional one percent return would have on the average individual’s retirement. In this analysis, it observed how much a 25-year-old investor’s investments would increase by the time they retired at 65, as well as how long it would take for them to run out of money during retirement. The analysis assumes a starting salary of $40,000 and annual salary increases of 3%, as well as annual contributions to their investments that are 10% of their salary. It then compared three scenarios of returns pre-retirement (5.5%, 6%, and 6.5%) and during retirement (4%, 4.5%, and 5%) to see how a half-percent and one percent return difference impacts the growth of the investments.

The investor’s baseline return (5.5% pre-retirement and 4% during retirement) saw an investment that grew to $886,415 by the time they turned 65 years old and lasted until they were roughly 84 years old. If the investor outperformed their baseline by half a percentage point (6% pre-retirement and 4.5% during retirement), they saw their investment grow to $992,680 and lasted until they were a little over 90 years old. If the investor outperformed their baseline by a full percentage point (6.5% pre-retirement and 5% during retirement), the investment grew to $1,114,177 by retirement and lasted until the investor was over 96 years old.

The one percent difference

By having a single percentage point better return, the investor saw over $227,000 in additional retirement savings and 12 additional years of retirement spending before their money ran out. Keep in mind, that is just an average difference using the previously-stated assumptions. An individual that contributes a greater percent, sees larger salary increases, retires later, etc. will see an even larger impact for achieving that extra percentage of return.

Now that we understand the impact 1% can have on an investor’s lifetime, investors must become active participants in their financial future. While a fund that has cheaper fees may sound good, what good is 1% saved in fees if the fund is not performing? Another fund may have a higher fee, but their performance could be 3% higher. In this case, choosing the cheapest fund was not the appropriate financial decision to make.

In conclusion

While the strategy of “set it and forget it” with cheap, passive index funds can be effective, it leaves potential results on the table, as illustrated by the previously-stated analysis. 401karat believes that it is not about “timing the market, but time in the market.” However, while time in the market is half the battle, being in the correct areas of the market at the right time is critical to the pursuit of that extra percentage point. That is why we observe trends in the market, whether it be sector trends like technology and real estate or style trends like growth versus value funds.

While the stock market is not an exact science, and corrections like the one experienced at the end of 2018 can feel as if they appeared out of thin air, aspects of it like sector rotation and style trends can be analyzed in a scientific manner. Through our prudent process of investment selection and performance monitoring, we can work towards achieving results for our participants. And, as we know, results matter.

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