Richard Wiegand

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Essentials of Investing: Lessons of Great Value

Lesson 1 How to become a millionaire investing conservatively

by the time you retire

Lesson 2 How to construct a safe, conservative portfolio that generates

meaningful returns

Lesson 3 Why cutting your losses is essential to growing wealth

Lesson 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 work

Lesson 7 Why most financial journalists, economists, financial advisors

and fund managers can’t preserve your wealth in down markets

Lesson 8 How complex investment strategies have destroyed some of the

most prestigious hedge funds

Lesson 9 Why the so-called “efficient market theory” is neither efficient

nor practical

Lesson 10 Why you can’t count on diversification to preserve capital

Lesson 11 Do stock price movements and charts exhibit random

behavior?

Lesson 12 What to do when your uncle Charlie starts to sound

like a stock guru

Lesson 13 Why the average investor is not very good at managing

stock portfolios

Lesson 14 Why psychological risk tolerance surveys are essentially useless

Lesson 15 Why options trading is dangerous to your financial health

Lesson 16 Why you should beware of automated trading systems or

“black boxes” with simulated or hypothetical back-testing

Lesson 17 Which is Better? Short-term or Long-term

investment strategies?

Lesson 18 Why day trading is for losers

Lesson 19 What are “cherry picked” trading performance results

and why you should be wary of them

Lesson 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 time

Lesson 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…

Lesson 23 Why it’s dangerous to make real estate the central focus of

your overall savings and investment strategy

Lesson 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

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 Einstein

Gilbert’s Millionaire Spreadsheet

When I taught a class in personal finance at an urban high school several years ago, a student by the name of Gilbert

approached 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 to

have a fruitful and productive future. He surely didn’t approach me if he thought that winning a lottery ticket or

getting in on some get-rich-quick scheme was the answer. After a few moments of thought, I said that if he came back

to me a day or two later I would be better able to answer his question. This gave me the time to design an Excel

spreadsheet that would not only answer Gilbert’s question – but to show him both numerically and graphically that by

following a disciplined investment savings plan over his working years, he could indeed retire wealthy. Imagine, you

too 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 to

project the value of a Roth IRA going out 40 years into the future. The spreadsheet may appear to be a bit

confusing at first, but with a little guidance it can be quite useful. This spreadsheet, entitled

PowerofCompounding_GilbertMillionaire.xls is downloadable on my personal investing blog at www.ProActInvest.net

web site.

Figure 1.1

As 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 expected

average annual return from your investments, as well as your tax rate. The tax rate is actually not relevant to this

case study, because we are assuming that we can invest the money in a Roth IRA. A Roth IRA is a qualified retirement

savings 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 per

year. 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 to

interest income – so retirees who live solely off of interest income from their savings accounts are not allowed to

make 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, or

403B). As long as you wait at least 5 years after you start making contributions and do not begin taking withdrawals

after age 59 ½ you will never be taxed on the money inside a Roth IRA. That’s a wonderful thing, because in a regular

taxable brokerage or bank account all your gains (whether interest or capital gains) are taxed, which dramatically cuts

into 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 (quite

literally) 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 would

be a situation where someone would live off the interest to pay for living expenses, for example. In this case, the

growth portion is basically used up each year and never plowed back into the account. The blue line doesn’t put the

interest portion back to work while the red line does. The chart shows that the spread between the two lines

increasingly widens over time – so much so that in 40 years the account with compound interest exceeds the

arithmetic account by over 4 times.

Let’s return to Gilbert’s spreadsheet for a moment. How much will Gilbert have in his retirement account by age 65

if we make the assumptions (highlighted with the cyan cell background) from Figure 1.1? Will he have enough to

retire on? Will Gilbert have $250K, $500K, or $1.0 million? What do you think? If Gilbert starts out his career at age

23 making $35K, receives pay increases averaging 1.5% per year and has the discipline to religiously set aside 10% of

his income each month for his Roth IRA, he will have contributed a total of $306,096 by age 65. (See the spreadsheet

snapshot below). But what about the growth on these contributions as well as the growth on the growth portions of

his investments? It turns out that if we assume an average growth rate of 7.55% on his investments, Gilbert will have

amassed a total portfolio value of $1,861,341! If we subtract the $306,096 of contributions to the account, that

means 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 to

retire 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 assumptions

here: for instance, we are assuming that Gilbert remains in good health during his working years and that no major

financial catastrophic events occurred in his family. We are also assuming that he is able to stay employed and

receives steady pay increases (which at 1.5% per annum are reasonable given that the average rate of inflation in

America has been 3.1% per year since 1926). We are also assuming that Gilbert is investing wisely and

conservatively. There will be much more on the subject of investing in later lessons (like how to get reasonable

returns of over 7% through conservative and moderate growth investment strategies, which by the way, I covered in

Gilbert’s class).

George and Martha – or, the importance of starting to save early

Another spreadsheet that I designed for my personal finance class was a hypothetical comparison of the savings

behaviors of George and Martha (Washington, one would presume). The spreadsheet emphasizes the importance of

starting 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 contributes

another $862. For the next 30 years or so, Martha makes no more contributions. From years 1-9, Martha has

contributed a total of $16,862 into her retirement account. Meanwhile, George gets off to a slower start. He doesn’t

contribute anything until year 9 ($1,138), and then for the next 30 years (until year 40) he is very diligent and

contributes $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!

Such is the power of time when it comes to compound growth. While striving for competitive rates of return may be

the noble objective of most investors, it is just as important not to lose sight of the importance to start saving early in

order to take the fullest advantage of the power of compounding.

Lesson Summary

Let’s wrap up some of the key points from this lesson. In order to take the fullest advantage of the power of

compounding, 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 Formulas

The 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 can

input any time period if you know the average growth rate (r) over a particular time frame. Say for example that your

stock portfolio has been averaging a gain of 1.3% per month over the past 4 months. You started out with $10,000 in

the account. (We will assume that this is a tax free account like a Roth IRA). To project how much you should have

after 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 = $11,676.52

In 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!

Both these formulas can be easily programmed into an Excel spreadsheet, either using the formulas noted above or by

plugging in built-in functions in Excel. Just go to Insert/Formulas/Insert Function to access an entire library of built-in

functions 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 series

of lessons, please consult my web site at www.proactinvest.net/educational .

Best of luck,

Richard Wiegand

ProActInvest.net