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In This Issue: Future Shock - How Much Money Will We Have, and When Will We Have It? Making Sense - Can Investing In International Funds Improve Portfolio Performance?
Future Shock - How much money will we have, and when will we have it? It’s always interesting to forecast how much money we will have in our 401(k) at some point in the future. The last several years of above-average returns have swelled 401(k) accounts to a greater size than any earlier calculations or assumptions would have predicted. None of us have, as they say, “more money than we know what to do with,” but on any scale we are probably (pleasantly) surprised with our progress. Where do we go from here? We can apply simple arithmetic and arrive at some future projections of our 401(k) wealth. Looking ahead, we have two kinds of money in our plan: First, we
have our current account balance, which will continue to grow
based on compound earnings, even if we stopped making further
contributions. We’ll call this Old Money For each type of “Money”, we apply a different formula to determine what each will accumulate to in the future. We then add the two sources together to get our totals in future years. So here goes. We will assume an average rate of return of 12.5%. Historically, the stock market has averaged 10% per year, but over the past twenty years the average has been over 15%. For purposes of this calculation, we will split the difference and assume 12.5% annual returns. Old Money Money at 12.5% doubles every 6 years. As an example, let’s assume we have $30,000 in our account today after about five years of participation. If that $30,000 doubles every 6 years, we will have the following buildup of this money alone:
That’s it for old money (If we actually have just $15,000 in our account today, just divide the above numbers in half.) New Money Let’s assume we have $5,000 per year deposited into the plan from a combination of our voluntary contributions plus any employer contributions. Special compound interest tables exist to help us determine future values of a stream of contributions. These tables give us the following results based on $5,000 per year contributed in monthly installments that then earn at a rate of 12.5% per year.
(Again, if your annual contribution is half of $5,000, then divide all these numbers by half…or double them if you are contributing $10,000.) So, to find out how much you will have and when, just add Old Money plus New money in each of the periods: Nest Egg Forecast Old Money + New Money = Total 6 years $60,000+$44,450=$104,450 12 years $120,000+$138,390=$258,390 18 years $240,000+$336,922=$576,922 24 years $480,000+$756,497=$1,236,497 30 years $960,000+$1,643,222=$2,603,222 That’s
it for someone with a current balance of $30,000 and future
contributions of $5,000 per year. Old Money is easy. Just take the account balance you have today and double it every six years. Want some additional tools? For old money, here are the doubling factors:
For new money, here are the multipliers that you apply for different percentage returns to calculate how much you will have in a specified number of years. One dollar per year invested at the beginning of each year will accumulate to the following values depending upon the following rate of earnings assumed:
So, for example, if you happen to be contributing $3,600 per year, and you assume you will make a 15% return, you can see that in twenty-four years your new money contributions between now and then will have accumulated to $851,328...($3,600 x 236.48). It doesn’t take much effort to see how 401(k) contributions will lead to capital accumulation that will someday be able to support not just an adequate but even a delightfully eccentric personal lifestyle.
When we read articles about, say, an internet mutual fund that is up 250% or “day traders” who have quit their jobs to make a living trading stocks, it can be depressing to view our own 401(k) investment returns which are undoubtedly less exciting. Ignoring these temptations is the ultimate test of the intelligent long-term investor. We have been here before. This time it is NOT different. In the twenty years following World War II, funds that invested in what were then the “tech” industries —aerospace, electronics, and automation — were very popular. However, only a few tech stocks made money in the long run, and many are no longer around...like Pan American Airways, the Microsoft of the early jet age. Pan Am’s stock increased to eight times its value in a year or so at the end of the fifties. Now they are gone. So, here we are again today. Technology funds and the stocks they buy are hogging the spotlight, but the history of these hot elements of the economy suggests that the boom and bust cycle is likely to repeat itself once again. It may not happen this year, but certainly in the new century we will see major corrections of this sector. Today’s hottest stocks are the ones that can be most easily eclipsed by new technology. It’s not that the tech industry itself is unproductive. Actually the contrary is true. The problem is the competitiveness and rate of innovation that makes great ideas quickly obsolete. Investors trying to pick winners have a difficult challenge. Every new technology is built on the bones of the last. Xerox, Litton, Polaroid, etc. —the “nifty fifty” technology stocks of the 1960’s lost almost ninety percent of their value in the mid ‘70’s. Xerox invented the fax machine and the personal computer, but didn’t see the potential and never bothered to exploit either product. When was the last time you bought a Polaroid Land camera or a pair of “Polaroid” sunglasses? For more history seeking to repeat itself, consider the early automobile industry of the 1920’s. Ford was private until 1956. Chrysler didn’t exist, and GM was just being assembled. The only companies you could really invest in at the time were the “hot” automobile stocks of Packard, Pierce Arrow, and others long forgotten. The “hot” technology stocks of the late 1800’s were the railroads. There were over 1,200 different railroad companies in the U.S. So, here we are writing this in June of 1999 after Amazon.com has lost 40% of its value since its high two months ago in April. Deja vu all over again. This less-than-enthusiastic discussion of technology stocks doesn’t mean that they should be ruled out. The point is that they are extremely volatile and should only be considered by someone who can accept a high level of risk, and who wants to be entertained by perhaps 5% or 10% of their portfolio. Many 401(k) plans today offer a small-company, aggressive growth, or technology fund. If not, then other non-401(k) savings such as IRA money or after-tax funds can be candidates for this subset of the investment spectrum...if it makes sense at all. The question
to ask is, “Am I doing this as part of my long-term investment
strategy, or am I driven by envy—the thought that I am
somehow missing out on a quick profit that others all around
me seem to be gaining?” Bottom line. If you feel a burning desire to invest in technology, maybe its best to go lie on the beach until the feeling goes away. After all, there is probably no 401(k) participant today who doesn’t already own some Microsoft, Intel and other technology stocks somewhere in their mix of run-of-the-mill name-brand funds. Relax. You’ve got the benefit of some technology-driven upside but with diversification to protect against the extreme downside.
When it comes to the impact of taxes on investment decisions, some experts say that taxes are simply a cost of doing business and should be ignored. Others say that, next to expenses, taxes are the most important consideration. Each point-of-view can be argued persuasively. When the dust settles, however, it is clear that by recognizing the impact of taxes on actively managed funds as opposed to passively managed funds and parking the ones with the most tax exposure in tax-deferred programs such as 401(k)s and IRAs, total tax expense can be minimized. First of all, we need to exclude from this discussion any tax-free funds (like municipal bonds), as these by definition should be held outside retirement plans. If held in tax-deferred plans, the funds and their gains become taxable at ordinary income rates when distributions are made, which defeats their purpose. Taxable funds are another story, and the decision about where to put them centers on the notion of tax efficiency. The term refers to the way a fund is managed (actively or passively) as well as the influence of changing investor sentiment and one’s own inclinations to move his or her investments around. Fundamentally, an actively-managed fund (one that actively buys and sells stocks in an effort to improve performance) is much more likely to generate and distribute significant capital gains than a passively-managed fund (index funds which have barely measurable turnover rates). For this reason, actively managed funds are less tax-efficient and should be sheltered in tax-deferred plans such as 401(k)s and IRAs. The same is true of any taxable funds that you plan to invest in if your habit is to move investments around frequently. In this case, you are the active manager, and your trading decisions can generate taxable income. If you move funds fairly regularly, then to be tax-efficient, keep your taxable funds—stocks or bonds (see table below)—in the tax-deferred portion of your portfolios. So, what kinds of funds beside tax-free municipals belong outside your 401(k)? Interestingly enough, index funds do, which seems to run counter to conventional wisdom. This is true even if you are not a buy-and-hold investor, because the index funds themselves tend to generate very little in the way of capital gains. Thus, regardless of your investing habits, index funds tend to generate the lowest total tax exposure. If you are fully invested in your tax-deferred programs, have your index funds in taxable accounts. If you have no room to shelter your other taxable funds, consider moving your bond funds to the taxable side to make room for more stock funds. This may be a least-worst choice, since bond interest is taxable as ordinary income. But bonds return far less than stocks over time, so the total tax exposure will likely be less. The following table illustrates the impact of an investing strategy that puts these principles to work.
When deciding how to allocate investments between tax-deferred and taxable programs, the investor needs to consider not only tax efficiency, but his or her tax bracket and investing time horizon. For example, an investor who will be in a high tax bracket before and after retirement is likely to find that conventional wisdom should be favored. Avoid what is known as “allocation drift”, a phenomenon that takes place as investment performance varies between the funds in your portfolio over time. At lease once a year you should examine your funds to see if the change in market value has altered your allocations relative to your objectives. If so, you need to rebalance your investments to restore your desired mix. An easy way to get started in selecting mutual funds is to read a few of the financial publications’ mutual fund surveys. These usually are based on risk-adjusted performance data and consider performance in both good and bad markets. Among the more well known are Money, Forbes, Your Money, and Fortune. Begin by selecting a group of funds that are ranked highly by at least two of the publications and then investigate these more closely.
Making Sense - Can Investing In International Funds Improve Portfolio Performance? In his landmark book on mutual funds first published in 1994, John Bogle wrote at some length about his skepticism that international funds add significant value to to the portfolio of the long-term investor. Among other things, he cited currency risk (the variability of the dollar against foreign currencies) as a negative influence. Some recent studies have, however, drawn different conclusions. As reported in the Fall 1998 Journal of Investing, a 26-year study indicates that risk may actually be reduced and returns improved by including so-called “risky” international funds in your portfolio. The study compared model investments in portfolios allocated in varying amounts between the S&P 500 Index and the EAFE Index (Europe, Australia and the Far East). During the study period the S&P 500 slightly outperformed the EAFE. Significantly, any combination of the S&P 500 and the EAFE outperformed either index individually. The study also showed that raising the EAFE allocation to as much as 40% of the total both raised returns and lowered risk. Given these results, it is clear that adding international funds to your portfolio is worth considering.
Indexes Prime Rate - 7.75% Fixed Mortgage 30 Year - 7.12%, 15 Year - 6.79% Home Equity Loan 8.73% Automobile Loan 8.11% Internet Sites www.mysimon.com Dow Jones Average History 12/94 - 3,834 12/95 - 5,117 12/96 - 6,561 12/97 - 7,908 12/98 - 9,181
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