Four easy steps to better returns
By Paul Merriman, FundAdvice.com
Monday, April 30, 2007
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. In this article, Paul Merriman tells how.
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-deferred 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 first 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 stock 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 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 un-loved 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 that 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 by 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, below.
Table 4: Investment results starting at age 21
Benchmark Using no-load fund Using no-load index fund Diversifying 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 lo-load index fund Diversifying 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 every 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, below, shows what we found.
Table 6: Investment results starting at 55
Benchmark Using no-load fund Using lo-load index fund Diversifying 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 your 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 the 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 your own money in retirement.
Assumptions in this study
The assumptions underlying this study are crucial to understanding the results. Here is what I assumed for the equity part of the portfolio:
Benchmark: Investor pays a 5 percent load in a large-cap blend fund with expenses of 1.18 percent (the Morningstar average) and a return (after expenses) of 11 percent.
No-load fund: Still a large-cap blend fund, but expenses drop to 0.84 percent (the Morningstar average), boosting return to 11.34 percent. Elimination of the load means more money is invested each year, for example $2,000 is invested at each birthday from 21 through 29 instead of only $1,900.
No-load index fund: Investor uses the Vanguard 500 Index Fund, with expenses of 0.18 percent. This boosts return to 12 percent.
Four-way diversification: Expenses rise to 0.23 percent (the average of Vanguard’s index funds in the four asset classes) while return from the four funds rises by two percentage points, to 14 percent. The net effect of these higher expenses and higher returns is a return of 13.95 percent.
Bonds: I know it is not realistic to assume an investor remains 100 percent committed to equity funds over a lifetime. So I assumed she shifts an increasing portion of her portfolio from equity funds to bond funds as she gets older.
The investor’s portfolio is 100 percent equities until her 50th birthday, at which time she invests 15 percent of the portfolio in bond funds. At age 60, 30 percent of the portfolio is switched into bond funds; and from age 70 forward, she balances the portfolio 50/50 between bond funds and equity funds. This of course will not fit everybody’s comfort level, but it is a reasonable way to reflect real-world investor behavior that I believe makes good sense.
Using the benchmark, I assume she pays a 4 percent load on bond funds with expenses of 1 percent and an after-expenses return of 5 percent. Once she moves to a no-load bond fund, I assume her expenses drop to 0.68 percent and therefore her return rises to 5.32 percent. Using an index fund, her expenses fall to 0.17 percent, increasing her return to 5.83 percent.
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