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In This Study
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Why It
Matters To Start Early
Triple Your
Investment
Returns In Four Easy Steps
by Paul A. Merriman
Publisher and editor, FundAdvice.com
The
first working title for this article was "How to Add $1
Million to Your Estate." My intention was and still is to
show how a few small things, if done right, can add up to a million
or more extra dollars by the end of an investor's life.
But very quickly I
realized that title was too modest. It could have been called
"An Easy Way to Add $8 Million to Your Estate and Another
$7 Million to Your Retirement."
Whether you're young
and just starting out, you're approaching mid-life and accumulating
savings or you're nearing retirement age, you can put a huge
number of extra dollars in your pocket and in the pockets of
your heirs if you just do a few things right.
Every year I speak
to high school students in the Seattle area, and I've developed
a little talk that always gets their attention. I call it "How
to Get Rich."
I tell the students
that if they will give me 45 minutes, I'll teach them more about
investing than their parents know. I tell them that what they
learn can literally make them millions of extra dollars during
their lifetimes.
The talk starts with
some fundamental choices they have to make, the most basic of
which is saving some money instead of spending it. We talk about
investing in stocks vs. bonds, in mutual funds vs. individual
stocks and about investing in tax-sdeferred vehicles like IRAs
vs. taxable accounts.
Then I tell them that
once they have decided to invest in mutual funds, there are basically
only four things they have to do right in order to be much better
investors than most of their parents. (I don't really mean to
be too hard on these young people's parents. A few of those parents
probably already are doing what I recommend, though I bet the
number is very small.)
Step 1: Worth $1.6 Million
The
fist thing I tell them to do is choose no-load mutual funds instead
of load funds. Unfortunately for investors, the majority of new
money invested in mutual funds is going into load funds.
Investing in a load
fund is like trying to fill a bucket that has two holes in it.
Imagine the frustration of pumping water into a bucket only to
have 4 or 5 percent of it immediately run out a hole in the bottom.
That is like buying a load fund, a transaction in which you agree
that part of your money won't ever be invested, but instead will
go to the salesperson.
Then imagine the further
frustration of discovering a tiny leak in the side of the bucket
that allows a continual trickle of water to flow out the side.
That is akin to paying the higher annual expenses of a load fund.
A young person who
does just this one simple thing can earn an extra $1.6 million
in a lifetime, as I will demonstrate.
Step 2: Worth $4.3 Million
The
second thing I tell the students they should do is invest in
low-cost index funds. Index funds have many advantages, but the
biggest one for the present discussion is low expenses. Cutting
expenses to the bare minimum, as you do with index funds, is
the equivalent of almost totally plugging the hole in the side
of a leaky bucket.
Average investors typically
own large-cap stocks funds, and the average fund of that type
has annual expenses of 1.18 percent, according to Morningstar.
But if you switch to the average no-load large-cap fund, you
will cut those expenses to 0.84 percent. The Vanguard 500 Index
Fund, the granddaddy of index funds and itself a large-cap blend
fund, has expenses of only 0.18 percent a year. The difference
is small in one year. But over an investor's lifetime, it's enormous.
A young investor, who takes the first two steps, buying no-load
index funds, can earn an extra $4.3 million in a lifetime, as
I will demonstrate.
Steps 3 and 4:
Worth $15.2 Million
The
third thing I tell them to do is to have half their money in
the stocks of small companies instead of having it all in the
stocks of large ones. Typically, adults invest in large-cap stock
funds because these seem the safest. Adults do the same thing
when they invest in individual stocks, buying familiar names
like Microsoft, General Electric and Coca Cola.
But if you have half
your money in stocks of small companies, over long periods of
time you can expect to receive an extra two percentage points
of annual return. In a year, two extra percentage points doesn't
seem like much. But over a lifetime of investing, it makes more
difference than most people would believe.
The fourth step is
to invest half your money in value stocks. These are companies
that are out of favor; their stocks are not in great demand and
can be bought for bargain prices when compared to those of the
popular growth companies. If you invest half of your money in
funds that own |these unloved companies, over time you can expect
to receive an extra two percentage points of annual return.
It might sound like
I'm saying one-half of your portfolio should be in small-cap
stocks and the other half in value stocks. But that's not it.
I'm advocating a four-way split, with 25 percent each in large-cap
growth stocks, large-cap value stocks, small-cap growth stocks
and small-cap value stocks. That way, you'll have half your money
in growth stocks and half in value stocks; and you'll also have
half in small-cap stocks and half in large-cap stocks. (To illustrate
this, I like to draw a simple diagram on the blackboard, and
sometimes I'll ask the students to help me get the percentages
right. It doesn't take them long at all to come up with 25 percent
in each of four style boxes.)
These last two steps
have the most dramatic effect on how much money a young person
can earn in an investing lifetime.
To recap, I tell the
students that their parents most likely buy large-cap stock funds
that charge a sales load. I tell them that if they change that
pattern only by using no-load funds, they can earn an extra $1.6
million. If they go further and use no-load index funds, they
can boost their extra lifetime earnings to $4.3 million.
Then I ask how much
extra they think they'll get if they go all the way and use no-load
index funds to diversify into small-cap stocks and value stocks
as I've just explained. Once in a while a bold student will suggest
the answer could be $8 million or even $10 million. But when
I tell them the result of doing all these things right is an
extra $15 million, they are amazed. (At that point, I sometimes
notice some students starting to write down what I've said!).
That's right: The payoff
can be $15 million just for doing four things:
1. Avoid paying loads
or sales commissions.
2. Keep your expenses
at rock bottom levels.
3. Have half the equity
funds in your portfolio invested in small-cap stocks.
4. Have half the equity
funds in your portfolio invested in value stocks.
International Equity Funds
Readers
familiar with my investment recommendations may notice that I've
said nothing about investing in international equities. Don't
assume this means I no longer advocate international investing.
Indeed, I still believe U.S. investors will benefit by having
half of the equity part of their portfolios in international
funds.
I have left out that
step in this discussion because I'm not convinced that adding
international funds would add significantly to long-term returns.
International funds certainly will add valuable diversification
and will reduce risks. Including them may increase the investment
returns I'm projecting in this article. But I don't believe that
additional step is necessary to illustrate the enormous advantage
of doing a few things right.
Although the greatest
benefit will go to young people, because of the long time they
have until the end of their investing lives, more seasoned investors
can benefit enormously, too.
I've done a series
of calculations based on assumptions that I think are reasonable,
conservative and realistic. One set of calculations starts at
age 21. Another assumes an investor "sees the light"
and takes these four simple steps at age 40. A third set of calculations
begins with an investor at age 55.
Now let's look at the
numbers and the calculations so you can see for yourself.
I began with some assumptions
about an investor, trying to strike a balance that represented
the behavior of someone who takes investing seriously without
assuming massive new investments every year.
Here's the investor
profile: Regardless of her choice of funds (purely for linguistic
convenience, I'm using the female pronouns throughout this article),
our hypothetical young investor begins at age 21 investing $2,000
into a Roth IRA on her 21st birthday. She invests that amount
every year through her 29th birthday. Starting at age 30, through
her 39th birthday, she adds $5,000 a year. On every birthday
from 40 through 49, she adds $10,000. Finally, from her 50th
through 60th birthdays (11 of them), she adds $15,000 a year.
This reflects the reality that young investors have less they
can put aside, and that people typically have more surplus funds
to invest later in life.
These annual investments
will be impossible for some investors, easy for others. But by
and large they are feasible amounts for a wide range of people
who make investing a priority in their lives. Roth IRA contributions
are limited to $3,000 a year ($3,500 for those 50 and over).
But 401(k) plans give enough extra room that many people can
invest these amounts in tax-advantaged accounts.
I assumed this investor
makes her last contribution on her 60th birthday and one year
later, at age 61, retires and begins drawing out the money.
I assumed a withdrawal
rate of 6 percent a year. In other words, she takes out 6 percent
of the portfolio on her 61st birthday, leaving the rest to grow.
Every time she has a birthday, she takes out 6 percent of the
portfolio, presumably a rising amount.
I also assume this
investor lives to be 86 and dies on her 86th birthday. (I know
this is rude, but we have to make assumptions about these things
in order to calculate results.) Whatever is left at age 86 goes
to her estate.
That set of assumptions
allowed me to compare different investment strategies in what
seems like a reasonable real-world setting. For each step that
I'm recommending, I calculated the size of her retirement fund
at age 61, her first-year withdrawal for retirement expenses,
the total of all annual withdrawals on 25 birthdays, from 61
through 85, and the size of her estate at age 86.
That way I can calculate
a "grand total" of all her retirement withdrawals plus
the amount left for her estate. In other words, all the dollars
that an investment plan would provide for her and her heirs.
For a benchmark to
represent what a typical investor does, I assumed all money is
invested in a large-cap mutual fund that charges a 5 percent
load. I had to pick a number to represent future performance
of such a fund, so I assumed 11 percent. This is not a prediction,
though I think it's within the ballpark of reasonable expectations.
It's based on the notion, supported by history, that a portfolio
of large-cap stocks can earn 12 percent before expenses.
This benchmark lets
me improve the portfolio in steps, first by using a no-load large-cap
blend fund, then by using a no-load large-cap index fund and
finally by diversifying into four asset classes using no-load
index funds.
Starting Young
Now
I'd like to share with you the hypothetical results of taking
these steps.
We'll start where the
differences are most dramatic, with a young investor who can
set aside $2,000 a year starting at her 21st birthday. If she
increases her contributions to $5,000 a year at age 30, $10,000
a year at age 40 and $15,000 a year at age 50, she will have
invested $333,000 by the time she is 60.
Investing in accordance
with our benchmark assumptions, she will build a retirement fund
of just under $2.2 million on her 61st birthday, when she's ready
to retire and take her first annual withdrawal. Her results are
summarized in Table 1.
| Table 1: Investment results starting at age 21 | |
| Benchmark | |
| Total investments over 40 years | $333,000 |
| Retirement fund on 61st birthday | $2,198,127 |
| First annual withdrawal, age 61 | $131,888 |
| Total withdrawals, 61 through 85 | $4,317,650 |
| Left for estate, age 86 | $3,540,241 |
| Total dollars to investor and heirs | $7,857,891 |
| Premium
over benchmark Percentage added to benchmark Dollars out for every dollar invested |
$23.60 |
Now, let's assume this investor takes only the first step and uses a single no-load large-cap fund instead of a load fund. This means all her money is invested instead of only 95 percent of it, and she has lower expenses. The results of taking this step are shown in Table 2.
| Table 2: Investment results starting at age 21 | ||
| Benchmark | Using no-load fund | |
| Total investments over 40 years | $333,000 | $333,000 |
| Retirement fund on 61st birthday | $2,198,127 | $2,500,712 |
| First annual withdrawal, age 61 | $131,888 | $150,043 |
| Total withdrawals, 61 through 85 | $4,317,650 | $5,111,302 |
| Left for estate, age 86 | $3,540,241 | $4,346,908 |
| Total dollars to investor and heirs | $7,857,891 | $9,458,210 |
| Premium over benchmark | $1,600,319 | |
| Percentage added to benchmark | 20.4% | |
| Dollars out for every dollar invested | $23.60 | $28.40 |
Notice
that by taking this first simple step, she has given herself
an additional $18,000 for her first year of retirement. She will
take out nearly $800,000 more during her whole retirement, and
she'll leave an extra $806,000 for her heirs. At no extra cost,
she has added 20.4 percent to her lifetime investment results.
Just as easily, she
can invest in a low-cost index fund instead of an actively managed
fund, reducing her expenses even more. Results of taking this
step (in effect, combining the first two steps) are shown in
Table 3.
|
Table 3: Investment results starting at age 21 |
|||
| Benchmark | Using no-load fund |
Using no-load index fund |
|
| Total investments over 40 years | $333,000 | $333,000 | $333,000 |
| Retirement fund on 61st birthday | $2,198,127 | $2,500,712 | $2,909,659 |
| First annual withdrawal, age 61 | $131,888 | $150,043 | $174,580 |
| Total withdrawals, 61 through 85 | $4,317,650 | $5,111,302 | $6,397,211 |
| Left for estate, age 86 | $3,540,241 | $4,346,908 | $5,797,845 |
| Total dollars to investor and heirs | $7,857,891 | $9,458,210 | $12,195,056 |
| Premium over benchmark | $1,600,319 | $4,337,165 | |
| Percentage added to benchmark | 20.4% | 55.2% | |
| Dollars out for every dollar invested | $23.60 | $28.40 | $36.62 |
As
you can see, the lower expenses of the index fund make an enormous
difference, giving her and her heirs a total of $2.7 million
more than if she had used an actively managed fund.
But, the best is yet
to come. By diversifying into four asset classes using no-load
index funds, this investor makes a quantum leap in her lifetime
results. You can see that in Table 4.
| Table 4: Investment results starting at age 21 | ||||
| Benchmark | Using no-load fund |
Using no-load index fund |
Diversify four ways |
|
| Total investments over 40 years | $333,000 | $333,000 | $333,000 | $333,000 |
| Retirement fund on 61st birthday | $2,198,127 | $2,500,712 | $2,909,659 | $4,508,716 |
| First annual withdrawal, age 61 | $131,888 | $150,043 | $174,580 | $270,523 |
| Total withdrawals, 61 through 85 | $4,317,650 | $5,111,302 | $6,397,211 | $11,486,490 |
| Left for estate, age 86 | $3,540,241 | $4,346,908 | $5,797,845 | $11,568,147 |
| Total dollars to investor and heirs | $7,857,891 | $9,458,210 | $12,195,056 | $23,054,637 |
| Premium over benchmark | $1,600,319 | $4,337,165 | $15,196,746 | |
| Percentage added to benchmark | 20.4% | 55.2% | 193.4% | |
| Dollars out for every dollar invested | $23.60 | $28.40 | $36.62 | $69.86 |
As
the final column shows, simple four-way diversification nearly
tripled the lifetime results of this investor, compared to the
benchmark. Her first-year retirement withdrawal more than doubled,
and she was able to leave $11.5 million to her heirs instead
of only $3.5 million. She (and her heirs) got back nearly $70
for every dollar she invested, compared with less than $24 for
the benchmark investor.
To do all this, she
didn't have to take big risks. She was conservative, adding some
bonds to her portfolio on her 50th birthday and cutting her equity
exposure to 50 percent by the time she was 70 years old. She
didn't have to save enormous amounts of money, because she started
early.
Over 40 years, she
put a total of $330,000 into the portfolio. By the age of 66,
she was withdrawing more than that total, every year for the
rest of her life.
Starting In Middle Age
Now,
let's look at some similar calculations for investors who start
at age 40 and at age 55, so you can see that it's never too late
to benefit from doing the right things.
I've calculated the
effects of taking each of these steps for a 40-year old, who
we assume has accumulated $100,000 by the time she joins our
program, with the same annual investments, the same mix of bond
funds and equity funds and the same retirement age and plans.
These results won't
be quite as dramatic as those for starting at age 21. But they
demonstrate once again that cutting loads, cutting expenses and
diversifying make a huge difference.
You'll see the results
in Table 5.
|
Table 5: Investment results starting at 40 |
||||
| Benchmark | Using no-load fund | Using no-load index fund | Diversify four ways |
|
| Starting balance, age 40 | $100,000 | $100,000 | $100,000 | $100,000 |
| Total investments over 21 years | $265,000 | $265,000 | $265,000 | $265,000 |
| Retirement fund on 61st birthday | $1,605,799 | $1,736,560 | $1,921,286 | $2,534,731 |
| First annual withdrawal, age 61 | $96,348 | $104,194 | $115,277 | $152,084 |
| Total withdrawals, 61 through 85 | $3,154,176 | $3,549,422 | $4,224,162 | $6,457,528 |
| Left for estate, age 86 | $2,586,255 | $3,018,606 | $3,828,393 | $6,503,434 |
| Total dollars to investor and heirs | $5,740,431 | $6,568,028 | $8,052,555 | $12,960,962 |
| Premium over benchmark | $827,597 | $2,312,124 | $7,220,531 | |
| Percentage added to benchmark | 14.4% | 40.3% | 125.8% | |
| Dollars out for very dollar invested | $15.73 | $17.99 | $22.06 | $35.31 |
The same easy steps that made a huge difference to a 21-year-old investor meant a lot to the one who started at age 40. By diversifying with no-load index funds, this investor more than doubled her total retirement withdrawals and more than doubled the size of her estate.
Starting Near Retirement Age
Finally, we did the same calculations assuming an investor "wised up" at the ripe old age of 55, only six years away from our presumed retirement age. We assumed this investor could start with $500,000 at age 55 and added $15,000 a year for six more years (birthdays 55 through 60). Table 6 shows what we found.
| Table 6: Investment results starting at 55 | ||||
| Benchmark | Using no- load fund |
Using no-load index fund |
Diversify four ways |
|
| Starting balance, age 55 | $500,000 | $500,000 | $500,000 | $500,000 |
| Total investments over six years | $90,000 | $90,000 | $90,000 | $90,000 |
| Retirement fund on 61st birthday | $1,003,838 | $1,036,336 | $1,062,141 | $1,153,196 |
| First annual withdrawal, age 61 | $60,230 | $62,180 | $63,728 | $69,162 |
| Total withdrawals, 61 through 85 | $1,971,774 | $2,118,208 | $2,335,236 | $2,937,903 |
| Left for estate, age 86 | $1,616,749 | $1,801,430 | $2,116,444 | $2,958,788 |
| Total dollars to investor and heirs | $3,588,523 | $3,919,638 | $4,451,680 | $5,896,691 |
| Premium over benchmark | $331,115 | $863,157 | $2,301,168 | |
| Percentage added to benchmark | 9.2% | 24.1% | 64.3% | |
| Dollars out for every dollar invested | $6.08 | $6.64 | $7.55 | $9.99 |
While
the results are not nearly so dramatic starting at age 55, by
diversifying four ways, this investor provided herself with almost
$1 million more during retirement and nearly doubled the size
of her estate.
If these examples don't
illustrate the benefits of diversifying while using no-load index
funds, I don't know what else will do so. However, I hope nobody
takes these figures too literally, because they are flawed. Two
of the biggest flaws are the failure to account for taxes and
inflation.
Don't let these tables
dazzle you with thoughts of the huge numbers of dollars that
you think you'll have to retire on. The calculations are as accurate
as I know how to make them, and if you follow this plan starting
at age 21, you could theoretically wind up with an annual withdrawal
of $270,000 in your first year of retirement.
But if inflation is
3.5 percent between your 21st and 61st birthdays, that $270,000
will be closer to the equivalent of $70,000 in today's dollars.
That's still not bad, but it won't be enough to support you in
a grand lifestyle. (However, if you are part of a working couple
and your spouse makes the same investments, you can assume twice
the results, for a much more attractive outlook.)
In the end, inflation
will be whatever it is. You have very little ability to predict
it or control it beyond keeping our own living expenses under
control. But if you do the right things, as we have outlined,
you'll still be way ahead even after inflation, compared with
the typical investor.
These calculations
are also flawed because they fail to take taxes into consideration.
Tax laws will inevitably change, and probably in major ways,
over the next 20, 30, 40 and 50 years. There is no way to predict
such changes. Nevertheless, under everything we know about taxes
now, you will still be much better off if you follow our four-step
plan.
I have assumed that
investments in these scenarios are made within tax-deferred or
tax-free accounts such as Roth IRAs and 401(k) plans. But even
if you must make most of your investments without any tax shelter,
investing early will almost certainly leave you with more money
than investing late.
Regardless of taxes,
avoiding load funds will give you more returns for your money.
Regardless of taxes,
keeping your expenses low with index funds will give you higher
returns. And unless capital gains taxes are radically altered,
the lower portfolio turnover of index funds will let you keep
more of your money working for you as you grow older.
And regardless of taxes,
diversifying your portfolio so that it includes small-cap funds
and value funds is likely to give you higher returns in the long
run.
Your Assignment:
Now
you have the information, and the question is what to do about
it. I have two recommendations.
For yourself, if you
are a buy-and-hold investor and you haven't already put your
equity investments in no-load index funds that include value
funds and small-cap funds, do so now. No matter what your age,
these simple changes are likely to significantly increase the
money you have for retirement and the money you can leave to
your heirs.
In addition, the information
in this article can be a great benefit to any young people you
know. But you have this information, and they probably don't.
I hope you will share this article with them. Encourage them,
and help them if that is appropriate, to start investing early
and wisely. It could be one of the greatest gifts you ever give
them.
And there's even an
added benefit for you as a parent or grandparent. If your daughter
or granddaughter knows how to get exceptional investment returns
on her own, there's less need for you to leave money for her
in your will. That means you can spend more of our own money
in retirement.
Editor's Note: Paul
Merriman is America's premier mutual fund educator. He is founder
and president of Merriman Capital Management, Inc., 1200 Westlake
Ave., N., Ste. 700, Seattle, WA 98109, a registered investment
advisory firm with over $300 million under management using buy-and-hold
and market timing strategies, and co-portfolio manager of the
Merriman Family of Mutual Funds. He is also the Publisher
and Editor of FundAdvice.com, a newsletter and hotline service
dedicated to investing in no-load mutual funds, 1 year, 12 issues,
$125.to The Hulbert Financial Digest, FundAdvice.com is
one of the top five newsletters on a risk-adjusted basis for
the 15 years ending March 31, 2000. FundAdvice.com was also named
"Best of the Web" by Forbes (in
2000 and 2001) and in 1998 the newsletter was one of only five
to be named to the Forbes Newsletter Honor Roll.
Paul Merriman is the
author of Investing for a Lifetime and Market Timing
With No-Load Mutual Funds. He has been widely quoted
in many national publications. Paul has produced three investing
videos including his recent 4-hour trilogy "How to Build
and Manage a Million Dollar Portfolio Using No-load Mutual Funds."
Mr. Merriman has a
library of over 100 articles on various investment topics including
the basics, retirement, psychological hurdles, market timing,
buy and hold and more posted on his award winning web site www.FundAdvice.com.
