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On Complexity, Diminishing Returns, and Personal Finance (Part 1)

Intro: The Pareto Principle Applied

Today I’m going to switch up my approach and instead of writing another guide, create a multi-part personal case study. Over the past decade and a half I’ve been fascinated by personal finance and investing and have read dozens (probably hundreds) of books, papers, and articles on the topic. I’ve also built up a pretty good nest egg.

That’s a lot of time spent, though—was it easily done? Not really. The vast majority of my results came from a few high-leverage decisions. The rest was instructive and enjoyable (for me), but your mileage may vary.

This is a textbook example of the Pareto Principle, which states that in many situations, ~80% of results come from ~20% of the effort. While the exact numbers are not important, the implication is that a large portion of results come from a few high-leverage activities and one sees diminishing returns after that. By identifying those activities and focusing your attention there, you can get better results, more easily.

Let’s explore what I did and see which decisions mattered, and which were just “for funzies.” Over the course of the next three posts, I’ll run through each decision and model its impact vs. the time spent.

The Early Years and the Most Important Decision

I learned a bit about the stock market in middle school, when prices were still quoted in fractions, but fortunately, I didn’t invest any real money. Picking individual stocks is as described in the lovely The Whole Kit and Caboodle (which is a lesson in stock picking wrapped up in a novel) is not a good way for the average person to invest because it is difficult to get sufficient diversification at a low cost. So… dodged a bullet there, although I guess I missed the big stock market run up before the 1999 tech bubble popped.

Our story continues and towards the end of high school, a friend turned me on to a great book (incidentally another financial guide wrapped in a novel, and this time aimed at Canadians… go figure), called The Wealthy Barber. While it’s a bit out of date now (here’s an updated version, sans the novel approach), this book contained the single most important nugget of wisdom that drove the vast majority of my results:

Invest at least 10% of what you make for the future.

It seems really simple, and at some level it is, but as we’ll see later this single choice drove most of my results. You could stop reading here and you’d still be way ahead of most people.

The book contained a lot of other advice, but the big pieces I took to heart were:

  • Start investing at least 10% of my income right now
  • Automatically take that money out of my paycheck upfront so that I won’t miss it
  • Put the money in a low cost mutual fund like the Vanguard 500 index fund
  • If possible, put the money in a tax advantaged account, like a Roth IRA

So that’s exactly what I did. As a broke college student, I didn’t really have much money to do this (10% of nothing is nothing), but I scraped together some dollars, opened up a Vanguard account, and was way ahead of most 19 year-olds.

My first model starts in 1975 with a 23 year-old saving 10% of their $10k per year salary, which was around the average salary back then. I assume that this person gets a 5% raise each year, which seems like a lot, but ends with that person retiring in 2018 with a $75k salary, which is also right around today’s average. Using the real yearly return from the S&P 500, our 23 year-old saver ends up with $1,283,742. Not too shabby.

Let’s compare this person’s results to someone who started saving at age 30 or who saved only 5% per year:

Save 10% starting at 23 Save 10% starting at 30 Save 5% starting at 23
Total saved $142,993 $134,851 $71,497
Total value $1,283,742 $706,755 $641,871

The results are compelling. 1975–2008 was a good time to invest in stocks, so much so that one shouldn’t expect results this good in the future. That said, the difference between $0 and nearly $1.3M is really meaningful. Halving the savings rate, unsurprisingly cuts the end result in half.

More insidious is starting late… it only reduces the amount you have to save by around 6% at the cost of reducing the total value at retirement by 45%! And that’s only what happens when you start 7 years late. At a baseline, it seems that starting early is the second best decision I made. The best: starting investing at all.

A Bad Time to Get Started?

Things didn’t really take off until I graduated from college and landed a real job. 10% of $75k is quite a bit more than $0. I was fortunate to make this much off the bat (more to invest) but I was also unfortunate to be starting my job in 2008 at the height of the financial crisis and the start of the Great Recession.

It was a scary time to be in the stock market. Prices were falling, so it felt a bit like shoveling money into a black hole. Worse, stock market performance correlates with the health of the overall economy as does most people’s likelihood to lose their job. I faced one layoff in my early career, which was scary, but I was still committed to my 10%.

A few facts helped me to stay the course:

  1. Given that the stock market always goes up over long time periods of time (true for the aggregate of all stock markets across the world, although not individually), temporarily falling prices are actually good because you can buy more stocks
  2. At my job I now had a 401(k), which included an employer match—that’s free money that I would be throwing away if I didn’t invest
  3. I had started to also build up an emergency fund with another 10% of my income, providing me several months of safety if I lost my job
  4. I was only committing 10% of my income to future growth; if I lost my job (but not before) I could just take a break and not violate my commitment to myself

I was fortunate and did not lose my job. The stock market did go back up, and the stocks that I bought at lower cost helped to improve my returns. More importantly, I learned something about myself from the Great Recession: when things got bad, I was able to stick to (or even double down on) my plan. Having this perspective gave me confidence to take on more risk and try some of the more out there approaches that I’ll talk about later.

Let’s quantify my decision not to bail by having me pull all my money out of the falling stock market, then putting it back in when it rights itself.

All In Bail at -10% Bail at -5%
Total saved $142,993 $130,086 $123,966
Total value $1,283,742 $1,102,751 $1,105,850

Here I test pulling out of the market if it goes down more than 10% (or more than 5%) in a year and not getting back in until it goes up for a year. You’d think that this sort of market timing might actually help, but in our backtest, it turns out that it doesn’t. In both situations, you end up with 14% less money at the end by trying to avoid bad outcomes.

Note that if your timing is even worse and you stay out of the market longer, the result would be worse. So right now, my decisions contribute approximately the following amounts to my terminal wealth:

  1. Start investing at all: 50%
  2. Invest 10% of my income (vs. 5%): 31%
  3. Start investing at 23 (rather than 30): 5%
  4. Stick with my plan and stay in the market: 14%

Digression: A Few Good Ideas and a Bad One

At the tail end of the Great Recession, I tried a few more things. My theme here was to limit my value at risk as I tried things, then ramp up what worked.

Pay Down Debt

My first good idea was to pay down debt. Given the success I was having and my passion for investing, I wanted to put more than 10% of my income into the stock market. However, I owed money for my studies. Mathematically, you will do best if you pay off any debt that has a higher financing rate than you can reasonably expect to get from your investments. Assuming a conservative rate of return of 5%, that meant that I should pay off any debt with a rate of higher than 5%.

I didn’t actually follow the mathematically optimal plan for psychological and motivational reasons. Instead, I did the following:

  • Commit a fixed portion of my income to paying off all debt in reverse order of size of the debt (this is like Dave Ramsey’s debt snowball plan)
  • Stay at 10% of my income dedicated to long-term growth and don’t increase it until all the debt above a rate of 5% is paid off
  • As I paid off debt, dedicate whatever portion is no longer going to debt to increasing the 10% I’m investing

This is not mathematically optimal, but I found it easier to stick to, which is critically important. By working through the loans in reverse order of size, I seemed to make faster progress through my backlog of debts. The feeling of momentum kept me going.

I also felt it was important to keep investing 10% for future growth regardless of debts. If I had some really onerous debts (like credit cards at 25%+) I may have taken a different approach. However, given that the cost of my loans was around or below what I would expect to make when investing, it made sense to continue putting in the 10% just so I could practice investing and build up a habit of doing so.

Finally, by switching the debt-paying money into investment as I paid off loans, I was able to increase my amount invested painlessly. Since I was just moving money from one bucket I couldn’t touch to another, it didn’t impact my lifestyle at all—a similar principle to taking the 10% out of my paycheck upfront. Incidentally, as I got raises at work I tried to do the same thing: put a significant percentage into investment upfront. That way I stayed off the hedonic treadmill a bit longer and had more to invest.

When I modeled this one and ramped up savings rate from 10% of salary to 20% of salary by age 30, the terminal value of the investments went up 68% to $2.15M. If you can save more, definitely do it.


My second good idea was to diversify further than the S&P 500 index fund. That fund relies on the performance of 500 of the largest companies in America. It’s done fantastically well historically and (critically important) it is very low cost. Costs matter.

That said, relying on one business is extremely risky; so many things can go wrong. Relying on 500 businesses is better. When one makes a mistake and does poorly, on average many others will be doing well. But 500 large American businesses tend to be correlated—what affects one may affect many of the others. Entire single country stock markets have failed in the past. We can do better.

I learned about the benefits of diversification from a variety of sources, but my favorites right now are the series of books by William Bernstein and the series of books by Larry Swedroe. Both highlight a few ways to diversify your risks at low cost:

  • Investing internationally
  • Investing in businesses of different sizes
  • Investing in fixed income securities (e.g. bonds, CDs)
  • Rebalancing your portfolio

Diversification can reduce your returns a bit, but it will also make your holdings fluctuate in value a lot less. Over time, this is a good tradeoff for most people.

It turns out that it’s possible to do all of these things with Vanguard by buying different mutual funds, so that’s what I did. I sold the S&P 500 Index Fund to buy:

Note that this is basically Bernstein’s “No Brainer” portfolio.

I also decided to rebalance back to these percentages every three months. It turns out that that was probably too often, but I like futzing around with my portfolio!

Now, let’s see how this change performs vs. the Vanguard 500 index fund approach…

S&P 500 No Brainer
Total saved $142,993 $142,993
Total value $1,283,742 $728,854

What gives? It turns out that over the period of the backtest, the S&P 500 had an annual average return of around 13.5%, which was higher than the index of small companies (13.3%), non-U.S. companies (12%), and especially bonds (4.6%). I couldn’t have guessed this upfront, except for the bonds which tend to have significantly lower returns than stocks.

The fact remains… diversification is not generally a significant driver of excess returns, and if you diversify into lower returning assets like bonds, it will likely reduce your returns. Diversification is mostly about reducing risks, not enhancing returns. Risk reduction is very important over the course of your investment horizon, which we’ll discuss more in a later post, but in terms of absolute end results, it pales in comparison to investing in risky assets like stocks as early as possible.

Pick Individual Stocks

Now for my bad idea… picking individual stocks. I love Warren Buffett. He’s made a fortune selecting individual stocks and buying companies by looking for great companies that are underpriced. This approach is called fundamental analysis or value investing. After reading some books about how he did it, I wanted to try my hand at stock selection.

I did some calculations, ran some screens, and bought stock in Adobe through Scottrade (which I would no longer recommend). I told myself I couldn’t spend more than 5% of my portfolio on individual stocks to mitigate my risk. Adobe went up and down a lot more than my other stocks, but it didn’t seem to do much better overall. And it was a lot of work to decide what to buy! Worse still, when should I sell it?

Based on my experience, I realized that in addition to the studies that suggest that having the ability to successfully beat the market by picking stocks was incredibly rare, my time spent was not being rewarded. And after seeing stocks in my then-girlfriend’s portfolio going to $0, I decided that even 5% of my portfolio was too much.

Why is stock picking so difficult? It turns out it’s just math. The nail in the coffin is this: since 1923, while the annual performance of stocks is much better than it is for bonds, this outperformance results from only 4% of the stocks. A full 60% of stocks had negative returns over the period. This positive skew is why stock picking is so hard. Do you think you can pick the right 4%?

It turns out that Warren Buffett doesn’t even suggest that individual investors pick stocks. He recommends more or less what I’m recommending here…

Conclusion: Was It Easily Done?

In this first post, we took a look at the most basic things I’ve done to build my nest egg:

  1. Start investing at all: 50%
  2. Invest 10% of my income (vs. 5%): 31%
  3. Start investing at 23 (rather than 30): 5%
  4. Stick with my plan and stay in the market: 14%
  5. Diversification across asset classes: 0%, but reduces risk

Next time we’ll dig in more on exactly how I reduce my risk and enhance my returns further and compare those techniques to these basics. Are they worthwhile? Subscribe to my newsletter to find out.