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Richard Wiegand Founder ProActInvest.netSign up today to get more FREE lessons on investing and to be the first to knowabout SIGNAL UPDATES from ProActInvest.net’s top performing trading models!Click here to take you to the ProActInvest.net home page where you cansubmit your name and e-mail address to get on the private client mailing list!
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Essentials of Investing: Lessons of Great ValueLesson 1 How to become a millionaire investing conservatively by the time you retireLesson 2 How to construct a safe, conservative portfolio that generates meaningful returnsLesson 3 Why cutting your losses is essential to growing wealthLesson 4 Why risk management (Defense) is far more important than directional strategies (Offense)Lesson 5 Know your history when it comes to the key investment asset classes (stocks and bonds)!Lesson 6 Only trust fund managers with proven track records, proven methodologies and who put their own money to workLesson 7 Why most financial journalists, economists, financial advisors and fund managers can’t preserve your wealth in down marketsLesson 8 How complex investment strategies have destroyed some of the most prestigious hedge fundsLesson 9 Why the so-called “efficient market theory” is neither efficient nor practicalLesson 10 Why you can’t count on diversification to preserve capitalLesson 11 Do stock price movements and charts exhibit random behavior?
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Lesson 12 What to do when your uncle Charlie starts to sound like a stock guruLesson 13 Why the average investor is not very good at managing stock portfoliosLesson 14 Why psychological risk tolerance surveys are essentially uselessLesson 15 Why options trading is dangerous to your financial healthLesson 16 Why you should beware of automated trading systems or “black boxes” with simulated or hypothetical back-testingLesson 17 Which is Better? Short-term or Long-term investment strategies?Lesson 18 Why day trading is for losersLesson 19 What are “cherry picked” trading performance results and why you should be wary of themLesson 20 Why trying to beat the S&P 500 or Russell 2000 Small Cap index by picking stocks is next to impossible over long periods of timeLesson 21 Are there any insurance products related to investing that are safe and worthy of consideration?Lesson 22 Here are two among the most dangerous phrases when it comes to investing…
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Lesson 23 Why it’s dangerous to make real estate the central focus of your overall savings and investment strategyLesson 24 What is Core-Satellite investing and how can I apply it to my own portfolio?Lesson 25 If it sounds too good to be true, it probably is
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Lesson 1: How to become a millionaire investing conservatively by the time you retire The most powerful force in the universe is compound interest. - Albert EinsteinGilbert’s Millionaire SpreadsheetWhen I taught a class in personal finance at an urban high school several years ago, a student by the name of Gilbertapproached me after class one day and asked me how he could get rich. “How can I become a millionaire?” he asked.I stopped and thought about how to answer such a loaded question. I was impressed with Gilbert’s sincere desire tohave a fruitful and productive future. He surely didn’t approach me if he thought that winning a lottery ticket orgetting in on some get-rich-quick scheme was the answer. After a few moments of thought, I said that if he came backto me a day or two later I would be better able to answer his question. This gave me the time to design an Excelspreadsheet that would not only answer Gilbert’s question – but to show him both numerically and graphically that byfollowing a disciplined investment savings plan over his working years, he could indeed retire wealthy. Imagine, youtoo can realistically become a millionaire and retire rich if you know how to harness the power of compounding!At home that evening I went to work designing a spreadsheet that incorporated simple future value calculations toproject the value of a Roth IRA going out 40 years into the future. The spreadsheet may appear to be a bitconfusing at first, but with a little guidance it can be quite useful. This spreadsheet, entitledPowerofCompounding_GilbertMillionaire.xls is downloadable on my personal investing blog at www.ProActInvest.netweb site. Figure 1.1As you can see from Figure 1.1, the spreadsheet asks you to input certain assumptions such as your starting salary,projected annual pay raises, how much you set aside each year (otherwise known as your savings rate), your expectedaverage annual return from your investments, as well as your tax rate. The tax rate is actually not relevant to this
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case study, because we are assuming that we can invest the money in a Roth IRA. A Roth IRA is a qualified retirementsavings account that anyone with earned income can contribute to up to a certain amount – today that amount is$5,000 per year for most individuals. (The Roth IRA is only accessible by individuals who earn less than $101,000 peryear. For further information on Roth IRAs, I suggest consulting the following page on Investopedia’s web site at: http://www.investopedia.com/articles/retirement/04/091504.asp Earned income refers to income generated from salary, wages, bonuses commissions or tips – it does not refer tointerest income – so retirees who live solely off of interest income from their savings accounts are not allowed tomake contributions to qualified retirement plans like a Roth/traditional IRA, 401K, or 403B).The beauty of the Roth IRA is that you will never be taxed on any of the money that you take out during retirement(any time after age 59 ½ ). This is because the money that you contributed to it during your working years was after-tax (i.e. you did not receive a tax deduction for each dollar contributed as you do with a traditional IRA, 401K, or403B). As long as you wait at least 5 years after you start making contributions and do not begin taking withdrawalsafter age 59 ½ you will never be taxed on the money inside a Roth IRA. That’s a wonderful thing, because in a regulartaxable brokerage or bank account all your gains (whether interest or capital gains) are taxed, which dramatically cutsinto your profits as well as into the growth upon growth effect.Compound growth is a lot like yeast that grows exponentially. The longer you let the yeast rise, the more dough (quiteliterally) it will produce. Most of the growth compounding takes place at later stages, not early on. As an example,consider the graph below that charts both compound interest (the red line) as well as simple interest (the blue line).The difference between the two lines is that the blue line does not assume that you reinvest the interest. This wouldbe a situation where someone would live off the interest to pay for living expenses, for example. In this case, thegrowth portion is basically used up each year and never plowed back into the account. The blue line doesn’t put theinterest portion back to work while the red line does. The chart shows that the spread between the two linesincreasingly widens over time – so much so that in 40 years the account with compound interest exceeds thearithmetic account by over 4 times.
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Let’s return to Gilbert’s spreadsheet for a moment. How much will Gilbert have in his retirement account by age 65if we make the assumptions (highlighted with the cyan cell background) from Figure 1.1? Will he have enough toretire on? Will Gilbert have $250K, $500K, or $1.0 million? What do you think? If Gilbert starts out his career at age23 making $35K, receives pay increases averaging 1.5% per year and has the discipline to religiously set aside 10% ofhis income each month for his Roth IRA, he will have contributed a total of $306,096 by age 65. (See the spreadsheetsnapshot below). But what about the growth on these contributions as well as the growth on the growth portions ofhis investments? It turns out that if we assume an average growth rate of 7.55% on his investments, Gilbert will haveamassed a total portfolio value of $1,861,341! If we subtract the $306,096 of contributions to the account, thatmeans that over $1,555,245 of the portfolio end value was due to compound interest (i.e. growth on growth).Amazingly, while it took Gilbert over 40 years of hard work and commitment to this savings and investment program,over half of the growth of the portfolio occurred during the last 9 years (ages 56 – 65)! And, if Gilbert decided toretire 2 years later at age 67 instead of at age 65, the portfolio end value would be $2,185,181 – an increase of$314,029 during the final 2 additional years.No wonder Einstein was so in awe of the power of compounding! Admittedly, we are making some key assumptionshere: for instance, we are assuming that Gilbert remains in good health during his working years and that no majorfinancial catastrophic events occurred in his family. We are also assuming that he is able to stay employed andreceives steady pay increases (which at 1.5% per annum are reasonable given that the average rate of inflation inAmerica has been 3.1% per year since 1926). We are also assuming that Gilbert is investing wisely andconservatively. There will be much more on the subject of investing in later lessons (like how to get reasonablereturns of over 7% through conservative and moderate growth investment strategies, which by the way, I covered inGilbert’s class).
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George and Martha – or, the importance of starting to save earlyAnother spreadsheet that I designed for my personal finance class was a hypothetical comparison of the savingsbehaviors of George and Martha (Washington, one would presume). The spreadsheet emphasizes the importance ofstarting to save early – of avoiding procrastination. A look at the George and Martha spreadsheet shows us why:Martha starts saving $2K per year in her (tax free) Roth IRA. She does this for 8 years, then in year 9 she contributesanother $862. For the next 30 years or so, Martha makes no more contributions. From years 1-9, Martha hascontributed a total of $16,862 into her retirement account. Meanwhile, George gets off to a slower start. He doesn’tcontribute anything until year 9 ($1,138), and then for the next 30 years (until year 40) he is very diligent andcontributes $2K per year into his Roth IRA. George has contributed a total of $63,138 into his retirement account.We are also assuming that the average annual return on both retirement accounts is 8%.The 64 million dollar question is: who has more money in their retirement account in the end – George or Martha?One would think that George would end up with more money, having contributed over 3.7 times as much as Martha.Yet the numbers show that George and Martha end up with about the same portfolio end values!
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Such is the power of time when it comes to compound growth. While striving for competitive rates of return may bethe noble objective of most investors, it is just as important not to lose sight of the importance to start saving early inorder to take the fullest advantage of the power of compounding.Lesson SummaryLet’s wrap up some of the key points from this lesson. In order to take the fullest advantage of the power ofcompounding, it is important to: a) Open up a Roth IRA which enables individuals generating earned income to save up to $5K per year. All interest income and capital gains in a Roth IRA are tax free. All withdrawals that you make (after age 59 ½ ) are completely tax free. b) Start saving at least 10% of your gross income in a qualified retirement account (ideally a Roth IRA). 401Ks are preferable to a Roth only if the company provides a match on your contributions. If the company match is skimpy or non-existent, go with a Roth IRA. c) Start saving early. As we’ve seen in Gilbert and Martha’s case, in order to take the fullest advantage of the power of compounding, one needs to accumulate as many years as possible. While it’s still better to start late than not at all, many years of growth on growth are foregone – as we saw in George’s case. d) Starting to save and invest early are more important than shooting for stellar returns. That is, 7% returns with a 10-year head-start are better than 10% returns after the fact. And, in striving for stellar returns, investors often get led astray down paths that are extremely speculative. Better to stick with a solid conservative investment strategy that you can live with.Relevant FormulasThe formula to project the future value of an investment is FV= P x ( + )^ where future value (FV) is equal to the original investment (P) multiplied by (1 + rate of return on the investment)raised to the (t=# of periods) power. Usually, investments compound at annual rates of interest, so t=1. But you caninput any time period if you know the average growth rate (r) over a particular time frame. Say for example that yourstock portfolio has been averaging a gain of 1.3% per month over the past 4 months. You started out with $10,000 inthe account. (We will assume that this is a tax free account like a Roth IRA). To project how much you should haveafter 12 months you could plug the following numbers into the future value equation:FV=10,000 x (1 + .013)^12 = 10,000 x 1.16765 = $11,676.52In order to calculate the periodic return of this investment program, we can use another formula:% Return = (New – Old ) / Old or verbally, “New minus Old (in parentheses) divided by Old.”In this case, the year-on-year percent return (always specify the time period when you discuss percentage returns),would be calculated as follows: (11,676.52 – 10,000) / 10,000 = 0.167 = 16.7% Notice that 16.7% is not equal to 1.3% (the average monthly return) times 12. That would give us 15.6%.So where did the extra (16.7% - 15.6%=) 1.1% come from? Well, you guessed it –compounding!
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Both these formulas can be easily programmed into an Excel spreadsheet, either using the formulas noted above or byplugging in built-in functions in Excel. Just go to Insert/Formulas/Insert Function to access an entire library of built-infunctions in Excel. To input the future value formula into a spreadsheet for the above example, type in the following: =FV(1.3%,12,0,-10000) {1.3% is the average monthly rate of return, 12 is the number of periods, in this case 12 months, 0 is input because we are not making any contributions or withdrawals over the remaining life of the investment program, and -10,000 represents the original investment as a negative number because it is money that we had to plunk down (otherwise known as a cash outflow – outflows are always negative, cash inflows are always positive – don’t worry, you’ll get your money back at the end of the investment program!I hope that you enjoyed the first lesson in this series on investing. For more information or to purchase the entire seriesof lessons, please consult my web site at www.proactinvest.net/educational .Best of luck,Richard WiegandProActInvest.net
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