A great deal!—to answer the title question. Three examples will illustrate the loss associated with active investing, or, stated positively, the gain from passive investing. The examples build on last week when I showed that active and passive investing had to achieve the same average gross returns. Yet active investing costs more, so in the end, the net returns to retirees are smaller with active investing.
Active investing links retirees with financial planners, brokers and actively managed mutual funds. Active investors believe they can identify low-priced stocks to buy, or that they can predict which stocks will drop in price so they can sell. In addition to individual stocks and bonds, they often buy actively managed mutual funds where a fund manager does the buying and selling.
Passive investing involves buying and holding all the stocks in the market, or as an alternative, a low-cost index fund that tracks the market, then riding the ups and downs through time to earn returns representing the market as a whole. On average, the market rises.
Active investors can’t generally beat the markets because those markets are efficient, which makes prices impossible to predict. If investors can’t predict prices, they can’t ever be sure when they are buying low or selling high. That means there really isn’t any good basis for picking stocks, at least no good basis that’s available to most retirees.
Because average passive and active investments must achieve the same before-cost performance, both can be estimated with the returns of a passive portfolio like that used in this blog before. The portfolio contains four Vanguard index funds covering domestic stocks, domestic bonds, international stocks, and real estate.
Today’s analysis includes returns from 1997 through 2011, which is a 15-year period or half of a planned retirement of 30 years. The procedure compares active and passive portfolios by subtracting active management costs from the average returns of the four markets, which are represented by the passive portfolio.
Three alternative results are shown:
- Base: $300,000 portfolio subject to a $12,000 annual withdrawal (4% of the initial amount)
- Base subject to an additional 2.25% annual cost
- Base subject to an additional 2.25% annual cost plus a 5.25% front load
The base analysis, which is the top line in the nearby chart, is simply the graph of the passive portfolio used before in this blog. It represents a retiree who has $300,000 at the beginning and withdraws 4% ($12,000) each year as a living allowance. The annual investment return data are from prospectuses for the Vanguard funds, and the low costs of passive investment have already been subtracted.
The middle line represents the base returns less the extra annual costs of active management, which are set at 2.25% annually. That number is derived from Internet sources that estimate typical annual costs of actively managed mutual funds (see here and here). I selected 1.5%. Index funds have costs too, which I set at 0.25% (the Vanguard funds average 0.21%, but not all index funds have those low costs). The additional annual cost for active management, then, is 1.25%.
An adviser fee—1% per year—is also subtracted, making the total, extra, annual cost of active management equal to 2.25%. See here and here to find other estimates of adviser fees. That total (2.25%) is subtracted each year from the portfolio to produce the middle line.
The bottom line of the chart also subtracts a “front load,” which is a sales charge common among actively managed funds. Many actively managed funds recommended by advisers include various “loads.” Some funds charge a front load when buying shares, and some charge a back-end load when selling shares. I used a front load of 5.25%, which is well within the typical range.
I did not include any marketing fees (12b-1 fees—named after a 1980 Securities and Exchange Commission rule authorizing them) or trading costs, both of which will be higher in actively managed funds.
The vertical axis is in thousands of dollars. The table shown nearby contains the plotted values.
Clearly, the most expensive parts of active management are the extra annual costs of advisers and actively managed mutual funds. The additional 2.25% takes a heavy toll—the ending portfolio value is $186,000 lower than the passive portfolio. The gap will only widen over the next 15 years.
When a front load is added, the ending value is lower still. The portfolio ends only $6,000 higher than the $300,000 the retiree had at the start, calling into question the portfolio’s ability to survive through a full 30-year period. Put another way, a passive investor ends the first 15 years of retirement with 71% more value in her portfolio. That will pay for a new car, several vacations, and many home repairs.
Retirees with modest portfolios near the amount tested here should surely rely on passive investing and learn how to buy index funds. It is not a complicated purchase, and the cost savings end up in the pockets of retirees rather than brokers, financial planners or active mutual fund managers. Retirees can still hire a fee-only financial planner occasionally to review their portfolios and plans. Vanguard offers low-cost personal service, including many different kinds of advice, as do several other providers of index funds. But a retiree need not pay 1% per year, nor be shuttled into high-cost active funds.
It is clear that the costs of active management are high. When a retiree begins to withdraw money each year, any additional strain on the portfolio prompts questions about whether the portfolio will last. That problem plagues active management.
Retirees may find it very hard to let go of the idea that investment professionals help achieve higher returns. But those who can let go will profit. Retirement can be much more than money, and ironically, the best way to enjoy it is to invest passively, earn more and spend time on life’s other pleasures.