Monday, December 22, 2014

How to Become a Millionaire the Simple Way ... Earn, Save and Invest ... The Key is in the Saving and Investing

When I was growing up in the 50's, a TV weekly show called "The Millionaire" was one of my favorites. At the beginning of each 30 minute episode, wealthy fictional character John Beresford Tipton, Jr. instructed his assistant to deliver a cashier's check for $1 million to a deserving and unsuspecting recipient. We never saw Tipton's face.

While Tipton wasn't real, of course, over a working lifetime most individuals who recognize and appreciate the different roles of earning, saving and investing have the opportunity to become "millionaires." Over the long haul, it's not how much we earn but instead what we save and how we invest those savings that will matter most.

The key is to do the right things in their proper order. First, we should avoid or minimize unnecessary debt, including large student loans. After completing our education, we need to land a good job, then discipline ourselves to spend less than we earn, and then set aside a healthy portion of those savings to invest in the ownership of blue chip stocks over the next several decades. That's it.

And while the educate, earn, save and stock ownership route to "millionaire" status may not be as easy as receiving a check from an unknown benefactor, it is definitely achievable, even though most people will never believe that to be the case. Here's why they are wrong.

The benefits of saving some of what we earn are enormous over time. The compound interest 'rule of 72' formula (an investment doubles each time the number of years multiplied by the percentage average annual return equal 72, as in 9 years x 8%) can work wonders for us, whether it's in the form of knowledge, skills, or financial returns.

A half a percent that can change your retirement offers this simple lesson concerning the long term beneficial effects of compounding:

"(Let's consider) the lifetime impact of gaining an extra 0.5% of annual investment return. . . .

The key here is to think about the long term. Many investors habitually think in terms of what we gain or lose in a short period: a month, a quarter, a year, a decade — or even all the years until we will retire. The accumulation phase of investing, in other words.

But the advantages of an extra 0.5% in return don't stop when you retire because your portfolio will continue working for you as long as you live. . . .

The long-term difference between earning a lifetime portfolio return of 8% and earning 8.5% . . . (is) a modest increase of about 6% in return in a single year.

But would you believe that seemingly small difference could boost your nest egg at retirement by 16%? Would you believe it could boost your retirement income by 24%? Would you believe it could boost the money you leave to your heirs by 31%? In each case, you should believe that.

Let's look at some numbers:

If you save $5,000 a year for 40 years and make only 8% (the "small" mistake), you'll retire with about $1.46 million. But if you earn 8.5% instead, you'll retire with nearly $1.7 million. The additional $230,000 or so may not seem like enough to change your life, but that additional portfolio value is worth more than all of the money you invested over the years. Result: You retire with 16% more.

Your gains don’t stop there. Assume you continue earning either 8% or 8.5% while you withdraw 4% of your portfolio each year and that you live for 25 years after retirement. If your lifetime return is 8%, your total retirement withdrawals are just shy of $2.5 million. If your lifetime return is 8.5% instead, you withdraw about $3.1 million. That's an extra $600,000 for your "golden years," a bonus of three times the total dollars you originally saved.

Your heirs will also have plenty of reasons to be grateful for your 0.5% boost in return. If your lifetime return was 8%, your estate will be worth about $3.9 million. If you earned 8.5% instead, your estate is worth more than $5.1 million.

To sum this up, at 8% your initial savings (totaling $200,000) turn into $6,447,194 — the sum of what you take out in retirement and what you leave in your estate. At 8.5%, the comparable number is $8,283,312.

That difference, about $1.8 million, came only from the extra half-percentage-point of return.

(There are) . . . places you are likely to find such a deal.

The most obvious place . . . is to invest in funds with lower expense ratios. A typical actively managed equity fund charges expenses of more than 1%. A typical index fund charges less than half as much. Bingo, you've got it done. . . .

A second place you are likely to find an extra 0.5% is to bump up your equity allocation by 10 percentage points. For example, you would have achieved that from 1970 through 2013 by investing 60% in equities instead of only 50%.

A third source of higher returns that is extremely obvious to me: Adding equity asset classes that have long histories of outperforming the S&P 500 Index . . . .

This is known as diversification, and it's one of the smartest things investors can do. . . .

There are plenty of other smart moves that investors can make to boost their lifetime returns, but if you act on one or more of these three suggestions, you'll likely add more than a half percentage point to your return."

Summing Up

The math works. And while acquiring wealth by saving and investing may not be the easiest thing to do behaviorally, it is both simple and very much doable.

If more individuals would internalize, understand and apply the compounding rule of 72 (investment doubles each time the percentage return multiplied by the number of years = 72), our financial lives would be comfortable ones.

Financial well being is not the equivalent of high earnings. Instead it's consistently saving and investing a portion of those earnings over a long period of time that matters most.

That's my take.

Thanks. Bob.

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