The high cost of expenses and emotions
But you can make up for it through a low-cost strategy and by avoiding the herd.
(Money Magazine) -- You've heard it a million times: Investing expenses and errors can be costly to your long-term gains. But how much do they actually cost you? One way to think about it is in terms of how much money you'll be able to live on in retirement. The difference in your standard of living can be dramatic.
Say you have $1 million in a mix of 50% stocks and 50% bonds. Returns can vary, but such a portfolio can beat inflation by 3.5 percentage points a year on average. Given those numbers, there's a good chance - 90%, in fact - you'll be able to safely pull 4% of your money in the first year of retirement, adjusting that annually for inflation, according to computer models known as Monte Carlo.
Based on $1 million, you could tap $40,000 in the first year of retirement and boost that 3% annually for inflation (so you get $41,200 in year two, $42,400 in year three and so on).
But you won't get to spend the full $40,000. That's because most of us invest through mutual funds. And the average fund investor pays 1.2% annually in stated expenses. On top of that, we lose an additional 0.8% a year in hidden expenses tied to fund trading costs. So you'll have to lower your expected annual returns by around two percentage points. When you do that, your safe withdrawal rate drops by $9,000 that first year.
Often, extreme bear markets like the one we're in cause investors to flee the market. Then they run back in after stocks recover. It's rarely an effective strategy. Studies show that poor timing decisions lead investors to underperform the market by about 1.5 points a year. So your safe withdrawal rate drops another $5,000.
The good news: You don't have to limit your withdrawals to a meager $26,000 a year. With two simple steps, you can boost your withdrawals back up to nearly $40,000. How? By investing in funds like Vanguard Total Stock Market ETF (VTI), you can keep expenses below 0.1%. And by sticking to your long-term plan and simply rebalancing your portfolio regularly, you can recapture 1.5% in lost gains.
To quote Warren Buffett, "Investors should remember that excitement and expenses are their enemies." Avoid them and you'll boost what you can spend in retirement by more than 50%.
Allan Roth is a certified financial planner in Colorado Springs.
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