TCS Daily

Pour It On, Now

By James K. Glassman - February 7, 2006 12:00 AM

Retirement begins in your twenties or thirties - or, better yet, at birth. That's when you should start investing to build a big enough nest egg so that you can live off income and capital gains from stocks and bonds, rather than off the sweat of your brow and your brain.

After 30 years of studying finance, I have found few eternal verities, but the most important -- the Golden Rule of Accumulation -- is this: Start early!

Time is the most powerful weapon in an investor's arsenal. In your fifties and sixties, or even your forties, you probably won't have enough time left to build a substantial retirement portfolio -- unless you own a business, work for a company that doles out generous pensions or have made some profitable gambles in real estate.

Let's do the numbers. The average annual return for U.S. large-company stocks (as represented by the Standard & Poor's 500 Index) for the past 80 years has been about 10 percent after transaction expenses but not taxes. Say your goal is to build a nest egg of $1 million by the time you are 55. If you start at age 24 and invest $5,000 a year at an average return of 10 percent annually - through, for example, an index mutual fund or exchange-traded fund (ETF) - then you'll reach your goal. But if wait until you are 34 to start, you'll accumulate only $357,000 by age 55. If you start at age 44, you'll have just $107,000.

Here's a second example, even more dramatic: One investor, call him Ishmael, begins, at age 25, to put $2,000 a year in a low-expense mutual fund with an average return of 10 percent annually. At age 35, he's put $20,000 into the fund. Then, he stops investing entirely. But, of course, the value of Ishmael's holdings keep rising, and, by the time he is 65, he has a portfolio worth $556,000. (We are assuming this is a tax-deferred account like an IRA or 401k).

Now, consider a second investor, Isabel. She, too, invests $2,000 a year at 10 percent, but she waits until age 35 to start. She keeps investing for a full 30 years -- a total of $60,000 out of her pocket. At age 65, Isabel's got just $329,000.

In other words, those extra 10 years (between ages 25 and 35) produce 70 percent more money for Ishmael at retirement time, even though Isabel's out-of-pocket investment is three times greater.

How can this be true? The answer lies in compounding, the fact that interest increases the value of interest as well as the value of principal. If you earn 5 percent on $1,000, then, after a year, you'll have $1,050. After two years, you'll have, not $1,100 but $1,102.50.

As time passes, the power of compounding accelerates dramatically. Imagine that when your daughter is born, you give her a one-time-only gift of $10,000 worth of stock. Assume that the stock appreciates at 10 percent annually, on average. On her tenth birthday, your daughter's stock account will be worth $26,000 (I am rounding up to the nearest thousand in all cases); that is, it will grow in value in that first decade by $16,000. But over the second decade, her account grows by $41,000; over the next, by $107,000; over the next, by $278,000. If the account were earning simple interest of 10 percent on the principal, without compounding, then growth would be a mere $10,000 per decade.

One other important fact about compounding is that a small increase in the rate of return you achieve can have a huge impact over time. In the case of a gift to your newborn daughter, if her portfolio returns 10 percent, then $10,000 grows to $4.5 million by the time she is 65. But if her portfolio returns 8 percent, then it grows to only $1.4 million. If it returns 5 percent, it grows to a mere $227,000. In other words, half the rate of return produces an account that's less than one-twentieth the size.

But enough numbers! If you're a young person, all you need to know is that you must start early. If you are an older person who has young progeny or young friends, encourage them to start early. If you're particularly generous, set up a long-term trust or a Section 529 tax-advantaged college savings plan, or simply open a mutual fund account that the young person promises not to touch (or better yet, doesn't know anything about).

The next step is deciding what to put into the account. What is the best investment for the next 40 or 50 years? No one can be certain what the world will look like in 2050, but here are some modest assumptions:

1. For the U.S. economy and U.S. companies, the future will look pretty much like the past. We can expect stock-market values to rise at roughly the same rate as they have over two centuries, a little over 10 percent annually, on average.

2. The power of "creative destruction," as the economist Joseph Schumpeter described the capitalist process, will lead to the decline, merger or bankruptcy of many companies that are currently flourishing.

3. No one can possibly predict which business sectors will enjoy the best growth in market value in the decades ahead. Right after World War II, for example, financial guru Benjamin Graham predicted a boom in the use of commercial airlines, but he warned that copious passenger-miles would not necessarily translate into copious profits. He was right.

4. Globalization will increase opportunities for investment outside the United States.

5. The greatest risk to the buying power of a nest egg will be inflation.

Add three more guiding principles, and you have the basis for devising an ultra-long-term strategy for investing for retirement: keep expenses low, watch out for taxes and diversify.

A simple but effective portfolio that would meet these criteria might look like this:

  • 50 percent U.S. large-cap stocks, held in a managed mutual fund with minimal expenses or in an index fund or ETF. 
  • 20 percent U.S. small-cap stocks, held similarly.
  • 30 percent international stocks, in managed or index funds or ETFs.

What, no bonds? Since 1926, according to the Ibbotson Associates data series, long-term U.S. government bonds have returned an annual average of about 5 percent; corporate bonds, 6 percent; stocks, 10 percent. After inflation, the differences are even more striking: bonds return between 2 and 3 percent; stocks, 7 percent. One dollar invested in large-cap stocks in 1926 grew to be worth $239 in buying power (that is, after inflation) by 2004. One dollar invested in Treasury bonds grew to just $6 in buying power.

The only reason to invest in bonds at all is to dampen risk. Bonds exhibit far less volatility in the short term than stocks, but, in the long term, bonds are just as risky as stocks, mainly because bonds are more exposed to the ravages of inflation.

And when you construct a Start-Young Retirement Portfolio (which I'll christen the SYRP, like the stuff you pour on pancakes), you have vast stretches of time in front of you - 30 years or more. Even for 20-year periods, stocks have been less risky than bonds. The Ibbotson figures show that, since 1926, the worst 20-year period for large-cap stocks produced average annual returns of 1.3 percent after inflation, which is only about one percentage point below the average period for bonds. The worst 20-year period for bonds? An annual average loss of 3.2 percent. To put it briefly: for the SYRP investor, bonds stink.

Volatility, however, is worrisome only if you might have to liquidate your investment. With a SYRP, such short-term needs are not an issue, except perhaps as you approach retirement. When you get into your 50s, you can start moving assets that you hold in tax-deferred accounts from stocks to bonds. In taxable accounts, you simply devote your new contributions to bonds and leave the stocks alone, to build up capital gains.

Which brings up the final point: pay attention to tax consequences. With tax-deferred plans like the 401k, 403b and IRA, capital gains and dividends build up tax-free (and should be automatically re-invested). But even a taxable SYRP doesn't have to generate much in the way of taxes if it's invested in a mutual fund like Dreyfus Appreciation (DGAGX) with an average annual turnover of just 8 percent, an indication that a typical stock is held for 12 years. The fund carries an expense ratio of a little less than 1 percentage point, and, over the five years ending Nov. 30, 2005, it's ranked in the top 70 percent of all funds in its category.

Of course, you can control turnover and taxes best if you manage a portfolio of individual stocks yourself. Be my guest, but recognize the Schumpeterian truth: Some companies are going to vaporize over the decades, and you'll have to pay attention to your holdings and make adjustments to your SYRP. Just remember that the key is to pour it on. Now!

James K. Glassman is a fellow at the American Enterprise Institute, host of the website, and chairman of Investors Action Alliance, an education and advocacy organization for small investors.


Retirement Funds?

What is your opinion on retirement funds (funds that as they get older move allocations from stocks to bonds, high to low risk)? I just changed jobs and moved my 401k into the Vanguard 2045 Retirement Fund namely because 80% of the allocation is in the Total Stock Market Index Fund, and also because I just wanted to move my money somewhere and forget about it.

Are they a good option for rollovers and IRAs?

Your Life Span and Your Nest Egg
“Time is the most powerful weapon in an investor's arsenal. In your fifties and sixties, or even your forties, you probably won't have enough time left to build a substantial retirement portfolio…”

At 10% interest, it takes about 73 years to grow a fixed principal amount 1000 times. That same principal invested on an annual basis would grow 11,562 times in the same 73 years at 10%. Given that the IRA/401k investment market has only developed into the mainstream in the last 20 years, many boomers never had the opportunity to begin accumulating their nest egg in their twenties.

A possible alternative for us "older folk" is to LIVE, work and invest longer! Anyone can be financially independent (ie…living acceptably from earnings on capital) with modest contributions (about 2000/yr.) over a 50+ year period.

If you couldn’t start your investment program when you were 25, start it today, and believe that you will have the opportunity to live to be 150…and thereby reap the rewards of an investment strategy for the long term.

Where do I find this fund?
I've seen some overly optimistic assumptions in articles like this, but c'mon. 10% a year? I used to get annoyed when I read about 7% a year. Is this realistic? If so, someone speak up and tell the rest of us where this fund is.

If the APY was an arbitrary number to demonstrate a point, okay, got it. But the difference in earnings realized between an investor who begins saving at 25 and one who begins at 35 are dramatically overstated with the 10% figure. A novice couple reading this article would conclude that they should forgo buying a home and keep renting so as to free up money to max out their IRA's. In this hypothetical world of the 10% return in lieu of the more realistic 5% return, the hypothetical home prices are not doubled, so this return on our magical 10% APY fund sounds mind-boggling. If we're going to inflate numbers then we need to inflate all of them and not a select few if we want our figures to make sense to the target audience of what is, in this case, an article directed at novices (who else would be unaware of the value of compounding interest?).

Real world - 2000 invested annually at 5% APY amounts to 75,000 after 20 years and 148,000 after 30 years.

Magic world - 2000 invested annually at 10% APY amounts to 140,000 after 20 years and 397,000 after 30 years.

A novice could using the real figures would conclude that forgoing the IRA in order to buy a house is a prudent decision, since the home would likely offset the difference in yield after 5 years. Using the magic figures, they would focus on the IRA rather than the home because, golly gee, we'd rather have $250,000 in the bank than a $125,000 home.

I enjoyed the article, but there are problems
The message to invest early and often is a great one, and which I was fortunately instilled with as a child. Though I work in a relatively low-paying job (about $25k/year), I invest 40% or more of income every month. I even if I were never to secure a better source of income, I'll always have assets to lean on--even if I only get a zero return.

The problem with the article is that it is far too optimistic about rates of return. While the 10% figure cited is genuine, this is a nominal rate of appreciation. Since the elimination of the gold standard in 1933, persistent inflation has been a fact of life, and since the last gold link was severed in 1971, inflation has been severe. If you believe government inflation figures, inflation adjusted common stock has a real return of around 7%. Of course, anyone who lives in the real world knows that government inflation figures are inaccurate at best and severely dishonest at worst, so you can figure your real return would be lower still.

7% still doesn't sound so bad, right? Wrong. First of all, everyone knows that you will have to pay fees. The good news here is that limited financial sector deregulation during the Reagan Administration, the internet, and competition are constantly reducing fees. In addition to fees, there's the capital gains tax. The very bad news about the capital gains tax is that it taxes nominal appreciation, so you have to pay taxes on inflation. For instance, an investor who bought into the Dow at its 1966 inflation-adjusted peak (not that you could buy a Dow ETF in 1966, but I digress) would not have broken even after inflation and capital gains taxes until 1999! 1999, you may recall, was close to the peak of a hyperinflationary stock market bubble.

Basically, whenever you invest, you need to be aware of inflation, and pay careful attention to tax implications. If you invest in an IRA, for instance, you will pay no taxes, so only have to watch out for inflation. I do not have an IRA simply because they're not flexible enough--if I need money immediately, the IRA severely penalizes you.

People should also look outside of stocks and bonds. In 2001, for instance, commodities in general were the cheapest they had ever been in the history of capitalism. Tremendous returns have been accrued in commodities in the past five years, yet they're still very cheap by historical standards (oil is far, far below its 1980 peak if you adjust for inflation, and the supply/demand dynamics are much worse today than they were in 1980). While it may not be possible to become an expert at every sector, if you can get a good grasp of general macro forecasting, you would be able to tell that stocks and bonds are both, in historic terms, overpriced today (though stocks are certainly cheaper than they were in 2000...). You could argue that we've entered a new era where historic modes of valuation are being replaced, but many people have argued that for hundreds of years and been wrong.

Remember that while stocks have always gone up in the long run, there have been secular bear markets that lasted a LONG TIME. The S&P Composite, for instance, was worth exactly the same in 1921 as it was in 1881. Fortunately there was no inflation in this time. If you bought the composite in 1929, you didn't break even until 1953 (not adjusted for inflation!). From 1982 to 2000, the US experienced and unprecedented bull run in stocks--far greater than anything before. This time period was not characterized by extraordinary economic or productivity growth in historical terms. For the last six years, stocks have essentially done nothing. While earnings multiples are lower than they were 2000, you're still looking at some historically expensive stocks. It follows that we're in for another long bear market (or are already in one).

Anyhow, I'll end my ramblings now, but my point is that while Mr. Glassman offers sound advice that never goes out of style, you can't be so optimistic.

start early
I took a slightly different tack, although not with any kind of foresight. After I finished my draft service, I stayed in the reserves. In a mere 35 years, I'm looking at a retirement very nearly equal to my current wage, one that will continue after my death in favor of both my current and ex-wives. Other upside: this part-time job has paid nearly $200K over the years. Think what I could have done with that if I had invested in something besides used cars! Downsides: service in vietnam, the first gulf scuffle, and I've just got back from 9 months in Guantanamo.

Social insecurity
Tragically, the gumint precludes retirement savings by forcibly taking from our workers over 12% of their pay, ostensibly for their retirement, but then they spend it all immediately, to buy votes to keep themselves in office.

IF; that money were placed in private accounts invested in diversified instruments at compound interest, we would be retiring ordinary workers as millionaires. They could then live on just the interest much better than on 'Social Security'. When they die, their kids could fight over the principal.

This would solve the unfunded liability of 'Social Security'. Money to bridge the changeover could be borrowed and would be much less debt than the current unfunded liability. Think about it.

Time Value of Money
Some things are obvious: Most people would rather have satisfaction NOW, then the possibility of satisfaction later. Get the big screen plasma TV now, rather than the better room in the retirement home later. Pure rationale vis-a-vis this subject will not cut it, as the retirement crowd has discovered that it can vote itself "bread and circus's". I predict both socialized medicine and complete retirement benifits paid for thru taxes by the time my fifteen year old son is old enough to retire. Anything you put away will be absorbed by the process to fund these plans. The writing is on the wall - The Republicans have caved and funded the current drug plan thru medicare - care to speculate on what the Dems will do?

A good article in the national review about Sarbannes Oxley pointed out what some of us in the business already know, that the US has lost its lead for capital formation for startups to london and luxembourg. We are now 5th in the world in this vitally important statistic we historically have led. The SEC has went nuts after missing the financial fraud of Enron in their staff reviews and has punished all small companies instead of fixing the problem internally. Leavittt's bias against small companies (shared by the SEC staff) in his recent WSJ editorial was evident for all to see. Sarbox is just a joke among accountants - forcing 1950s ideas in the 21st century. There is a list of big sins our own government has brought upon us that I will not develop here (504s, anti-reverse merger rules (the Chinese think we are nuts), bizarre enforcement behavior like Global Warming's non-fine while petty offenses get the book thrown at them).The economy for engineers (one third of all engineering jobs gone in 6 years) and other professionals that illustrates the point no one seems to grasp. If we reverse the mistakes of this decade we can recover, but expect things for the nation to get a lot worse in a hurry if we dont streamline the SEC and state regulation, review and enforcement process in a hurry. Young people, invest in another country until this gets fixed - remember our markets havent moved in the 6 years since the SEC began this craziness!

TCS Daily Archives