A reader recently got in touch to ask about the merits of investing in funds versus individual stocks. For the most part I think this is the solution for most folks out there. I mean your average Joe doesn’t really care about why Coca-Cola is a better long-term bet than Alcoa. He just wants to allocate his savings in the most efficient and convenient way possible. Keeping tabs on the ups and downs of individual companies just doesn’t appeal in that sense.
Now, ask an active stock investor about the limitation of funds. What would his answer be? I’d wager he might say two things. Firstly, he might say that most active fund managers can’t beat the market anyway. Secondly, the returns of the passive index funds are capped by the performance of the index in question. This second point is not a big deal. I mean the average annual long-term return for the S&P 500 is something like 10% anyway. The first point though is a crucial one, and it is why you are nearly always better of sticking to the lower cost passive index funds.
Compounding’s Butterfly Effect
Consider the historical returns of Coca-Cola and PepsiCo. To nearly all intents and purposes these were identical investments in the latter part of the 20th Century. Indeed between 1957 and 2003 there was just a minuscule 0.01 percentage point difference in the average annual earnings per share rate of the two companies. (11.23% per annum for PepsiCo versus 11.22% for Coca-Cola in case you were wondering). As it turned out Coca-Cola actually ended up returning more for investors over the period in question. (16.02% per annum total returns for Coca-Cola stock versus 15.54% per annum for PepsiCo – assumes continual dividend reinvestment).
Now you might be reading that and thinking that there isn’t much there. After all, 0.48% per annum sounds like a pretty small difference. That said just consider the situation in absolute dollar terms. On a $1,000 initial investment that half a percentage point compounding away for just over fifty years would have been worth just over $160,000 to the Coca-Cola investor over the PepsiCo one.
With a bit of luck you see where I’m going with this. Saving as little as 0.1% per annum via a combination of choosing the lower cost “passive” funds and being as tax efficient as possible can really pay off down the line. Unfortunately some folks gloss over it because the difference is small initially.
For instance let’s imagine having a lump sum of $50,000 to put into a S&P 500 tracker fund as a long term investment. The difference between an annual fee of 0.05% and 0.15% is less than the cost of dinner in year one. But remember, this is only if you stop counting at that point! Imagine holding said fund for forty years. The total savings could be worth tens of thousands of dollars – nearly as much as the initial investment, assuming the fund generated annual returns of 10% per annum before fees.
The same argument applies to holding your funds in the most tax efficient way possible. Max out tax-free saving vehicles before investing in regular accounts. What sounds like a few dollars here and there has a habit of turing into a few thousand dollars (or even tens of thousands) down the line.