Thursday, November 29, 2012

"How To" Be an "Einstein" Investor ... Invest in Stocks for the Long Haul and Realize Strong Average Annual Returns

I once heard that the 8th wonder of the world was compound interest. I think that just about gets the following story about individuals investing successfully right.

Invest like Einstein tells a very simple story about the benefits of owning a heavy concentration of, if not all, stocks as investments in our individual investment and retirement accounts.

Included are several examples of the simple math that confirms the inherent "wisdom" of taking the long term view when investing. Combined with adopting a largely DIY approach, it's the safe and winning way to satisfying an individual's long term investing needs.

I use an "Einstein like" methodology of regularly investing in blue chip, dividend paying and growing stocks, and then sitting back and watching the magic of compound interest work its simple magic.

Here's what the above referenced article has to say:

"Albert Einstein once described compound interest as the greatest invention of mankind. Smart investors put Einstein's insight to work for them.

These days, many unsophisticated investors seem to thumb their noses at Einstein as they engage in a mad quest for safety above all else. Ironically, they may wind up later with less security instead of more.

Yes, you can choose safe, "guaranteed" investments for your 401(k). But you'll most likely be stuck with returns of only 3% to 4% — just enough to keep you ahead of the long-term historical rate of inflation. To have a comfortable retirement at that rate, you'll have to save much more money while you're working.

Einstein's work revolved around numbers, and I'm going to throw out a few. Over a lifetime, an increase of just two percentage points of return is stunningly dramatic, as I pointed out in several tables that are part of my 2012 book First Time Investor. Here's a sample.

Many young investors can save $5,000 a year, the current maximum for funding an IRA. To illustrate Einstein's genius, I calculated the hypothetical results of doing that for 40 years, for instance from age 25 to 64, at various rates of return.

An investor who gets a low-risk return of 4% could wind up with $475,128 after 40 years. But if his long-term return were 6% instead, he could have $773,810.

Think about the difference between those two numbers: $298,682. Over the years, this investor made 40 investments of $5,000, for a total of $200,000. Boosting his return by two percentage points — which should not be particularly difficult or risky — adds nearly 1.5 times the investor's entire lifetime contributions to his retirement nest egg.

As Einstein would instantly notice, one small change has a huge cumulative effect. And that's only the start.

Financial planners teach that it's possible to safely withdraw 4% of a portfolio's value annually in retirement. Applying this rule of thumb, the investor who achieved 4% could take out $19,005 in his first year of retirement. The one who earned 6% could take out $30,952. That makes a huge change in the investor's retirement lifestyle.

There's more: If you assume the same investment return continues for 30 years of retirement, the portfolio can grow even while it's paying out retirement income. With a 4% return every year for 30 years, you can take out a total of $557,121; at 6%, your lifetime withdrawals become $1,209,551.

It's even better than that. After 40 years of savings and 30 years of retirement, the investor who got a 4% return would have $452,843 to leave to his heirs. The investor who got 6% would have more than three times that much: $1,306,012.

To recap: At 4%, your $200,000 of lifetime savings gives you $557,121 in retirement plus $452,843 after 30 years. At 6%, the same $200,000 contributions give you $1,209,551 in retirement plus $1,306,012 after 30 years.

The totals: At 4%, $200,000 of savings produces a little more than $1 million in total benefits. At 6%, the total benefits are about $2.5 million. It doesn't take an Einstein to see why this is worth thinking about.

An obvious question is how to obtain the higher return. While nothing - and I really mean nothing - is guaranteed, the long-term history of investment returns shows that you don't have to take much additional risk to boost your expected returns from 4% to 6%. Going from all-fixed-income to a 20% or 30% equity position is likely to do the job - with very little extra risk.

You can increase your returns in other ways as well. Keep your expenses low, ideally by using index funds or exchange-traded funds. . . .
Finally, if you're interested in notching up the returns even more, consider the results of achieving a long-term return of 8%. At that rate, the same $5,000 a year of savings would grow to $1,295,282 after 40 years, producing a first-year retirement income of $51,811, total retirement distributions of $2,755,274 and leaving $3,830,134 after 30 years.

If you can achieve that, your family and your heirs might think you were as smart as Einstein."

Summing Up 

On average an investment in stocks is highly likely to earn 8% annually and perhaps more over a long period of time.

A mixture of stocks and bonds will dilute those returns, but for those having trouble sleeping at night with an all stock portfolio, perhaps it's best to start at 60/40 or so and then gradually work up to 90/10 or even 100%.

For a long time, I've pretty much been a 100/0 investor and remain so today. And I usually sleep just fine, old age issues excluded.

And as for timing, stock valuations today are not excessive. Not even close.

So while I don't pretend to be Einstein, the investment math is easy, and I internalized the rule of 72 years ago. 

In the long run, stocks have always easily outperformed other forms of investment.

So now all that's needed is our individual decision to embrace a DIY approach to investing in blue chip stocks (such as an S&P 500 Index Fund) for the long haul. 

We don't have to settle for 4% to 6% average annual returns in our retirement accounts.

In fact, the all stock route to average annual returns of 8% or higher is a simple and effective approach to achieving a comfortable and secure financial future.

At least that's my view.

Thanks. Bob. 

1 comment:

  1. "The Rule of 72"
    Divide the interest rate received into the number "72" to determine the amount of time needed for that principal amount to double.
    Ex: 72 divided by 6% (compounded interest - or, accruing earned interest is added entirely to the principal amount or, one earns "interest on their interest")will double the amount invested in 12 years. (72/6=12yrs or, $100,000 originally invested will become $200,000 in 12 years for example) Compound interest, when charted over a several decades-long time frame shows a chart line that will eventually go "through the roof" doubling ever higher and ever doubling principal amounts. Many have never heard of "The Rule of 72" I've determined. (Pleased that you brought it up.) It's possibly the origination of the financial truism..."Money goes to money" or, maybe "time is money" as well no? (Si!)