A tale of two investors
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?
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.
I make my Roth contrib the following year (before April 15) since I don’t know whether or not I will meet the income requirements at the beginning of the year. I am on commissions thus my income is difficult to predict and varies widely from year to year.
If you make all of your contributions for the year in a lump sum, that doesn’t really take advantage of dollar cost averaging. Is a large contribution on April 14th actually common? I’d be much more interested in a comparison between a lump sum contribution in January versus regular monthly contributions.
Are you saying that investor A had 1 more year invested than investor B?
158123*1.07 = 169191
If that is the case, no the investors are not identical. One was invested for 25 years, the other was invested for 24 years.
On the other hand there are reasons to wait and see before deciding how to split the $5k or $6k (per spouse) IRA contributions between traditional and Roth, since you can use this to fine tune your AGI to the optimal level. (For example see Form 8880 for an example of how lowering your AGI by $1 could lower your taxes by hundreds of dollars.) But you need to wait until at least the January following the tax year, to get W2,1099′s etc to know your exact tax situation if you didn’t already know it to the exact dollar amount beforehand.
Also waiting like this needn’t mean you miss out on having that money invested in the market in tax-advantaged accounts as long as possible, since you can instead direct that money first to maxing your 401a/401k/403b/457 contributions as quickly as you can.
Do I understand correctly that Investor B keeps his money in cash under the mattress while procrastinating?
As to lump sum vs dollar-cost averaging into a Roth IRA, I put my entire yearly contribution into a money market fund within my Roth, then move that money periodically into the other funds within the Roth.
Well, I think that it is hard to predict if a Market will be up or down in January or in December….sometimes prices are lower in December to purchase stock shares …..every year is different…I know that sounds like Market timing but also common sense.
I wonder the value of DCA over the year with a bit extra thrown in at the beginning. Most years stocks increase over the year, but there can some drastic price swings in between…
Would the reverse be true? I.e. for those of us who want or must take IRA/401/403 Minimum Required Distributions or other payouts, should we do so in Dec of the required year?
Hypothetically, it’s an interesting study. But a fund increasing at a constant rate and an account compounding steadily is not reality. Looking at another hypothetical scenerio: suppose the fund went sideways all year, and only made 7% gains in the last month, the disparity between investor A and B’s gains would not be that great.
Does anyone know what alacrity means?
Are your Average Annual Results the same as Compounded Average Annual Results? Thanks
The graph makes the difference look huge! One column is twice as high as the other which is misleading as the difference in total amount is only $11,068.00 , significant but not as bad as the graph makes it look.
Since the stock market returned 0% over the last 10 years where did these guys get a steady 7% for 25 years because I want to do whatever they did.
This point was well put, and greatly received. Thank you.
Yes, but looking at everyone’s situation, it can be different.
Perhaps the person who contributed at the end of the year only did so because that’s when their emergency fund cushion allowed them to contribute at that time.
The point would have been better illustrated if investor B waited to invest for 5 or 10 years. That would be a significant difference. This would show us the cost of waiting. The difference in this case is closer to $11,000 than $12,000 as illustrated. The graf is way out of line for comparison sake. Since this was written in 2010, why not use the real IRA contribution amount limit rather than $2,500?
Your graph exaggerates the benefit. The reader appreciates the information but feels tricked and betrayed when you can’t be straight about it.