A tale of two investors

Posted by on January 25, 2010 @ 8:12 am in Investing

Here’s a pretty simple chart showing hypothetical investment results for two hypothetical investors. Each of them saved $2,500 a year for 25 years, using investment strategies that delivered identical 7% rates of return each year. After 25 years, one investor ended up ahead of the other by more than $11,000. Can you guess why?

A tale of two investors

Data source: Vanguard. These results are hypothetical and do not represent the returns for any particular investment.

This being the Vanguard Blog, you might guess that I cooked this up to illustrate the importance of lower investment costs. That’s a good guess, but the answer is that “Investor B” made his deposits at the end of each year, while “Investor A” did so at the beginning—giving his money an extra year to compound. So, when it comes to saving, diligence and alacrity can matter nearly as much as cost.

And make no mistake: costs absolutely do matter. Let’s say our hypothetical investors both made their $2,500 deposits at the beginning of each year, but paid different amounts in management fees—say 20 basis points for one and 70 basis points for the other. Even assuming identical 7% annual returns, the investor paying lower costs would outperform the other after 25 years by almost $12,000.

So, costs do count. Over time, that seemingly minor difference in expenses—one half of one percent—had even more of an impact than when the investors made their deposits, which is the main difference I wanted to highlight here.

The bottom line: Just as we at Vanguard want investors to pay more attention to costs, we’d also love to see more IRA contributors get the advantage of an extra year of compounding by making their deposits on January 1 of each year, as opposed to April 15 of the next.

Note: All investments are subject to risk.

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