One of my closest friends (let’s call him Kevin) is obsessed with individual stock picking. He bragged to me quite loudly recently that his portfolio was up 15% for the year so far, which is pretty good – and I told him so. I asked him how much his net worth increased, though, and I found out that he didn’t even bother to calculate it. In fact, I’m quite aware that Kevin is swimming in credit card debt and payments on a leased Lexus and a house that he probably shouldn’t be in because it’s out of his reasonable price range.
The truth is that personal finance success comes from smart budgeting and frugality, not from chasing a couple more percentage points on an investment. Let me show you what I mean.
Let’s say Kevin and I both make $50,000 a year. Kevin spends his spare time chasing individual stocks; I spend my spare time looking for frugal living ideas. Kevin spends $45,000 in a year and is thus able to invest $5,000 a year, while I, through budgeting and frugal living, only spend $40,000 in a year and am thus able to invest $10,000 a year.
Now, Kevin’s a smart investing cookie and is able to crank out a 16% return each year. I just take my money, dump it in a Vanguard 500, and move on with life, which means over the long haul I earn a 12% return. Who earns more in the long run?
After five years of this same investing, Kevin has $34,385.68 in his investment account, while I have $63,528.47 in mine, a difference of $29,142.79 in the frugal guy’s favor. Even at the twenty five year mark, if the investments have continued for that long, Kevin has $1,246,070.12 in his account, while I have $1,333,338.70 in mine, a difference of $87,268.58.
This is assuming no taxes, of course; since mine has just been sitting there in the Vanguard 500, I will have incurred no tax penalties and when I take it out, virtually all gains will be long-term capital gains (with a very low tax bill), while Kevin has had to actively manage his portfolio and will have taken some serious tax hits in there which aren’t included in these numbers. In reality, Kevin is even further behind because making tax guesses only reduces Kevin’s number and has almost no effect on my number.
If you move the threshold out to thirty five years or so, Kevin is ahead – the power of compound interest does eventually win out – but, again, this is assuming no tax hits along the way.
What can we conclude from this? Unless you’re very young and aiming solely for retirement, you’re better off spending your time budgeting and living frugal than digging for a better investment. As long as your return is solid, you’re better off just leaving an investment alone in an index fund somewhere and not worrying about it than battling for big returns. Instead, spend time doing what you enjoy or doing things that save you money in your budget so you can invest more in your fund.