Wednesday, 19 September 2012

Helping the small investor: The Magic Formula

Why the Formula Matters
Many hard working, middle class people find it very difficult to make ends meet, never mind make the appropriate contribution to their retirement savings. Even those that are making regular contributions to retirement savings find it unlikely their nest egg will grow large enough to let them live the dream retirement.

There is a hope! Before we get to the impact of the magic formula, you need a specific goal. Find out how much you need to retire. Use one of the online calculators to find your number and write it down.

Whatever number you came up with, chances are it shows that you should be saving more for retirement, correct? But what if you really have cut back as much as you can, and you still can't find that extra money to fund your retirement? Answer: If that extra income in not available in your budget, your retirement funds must earn more. Not paying attention to this fact is the single biggest risk you have to a happy, financially secure future. One of the great things about retirement accounts is that your earnings grow tax-deferred so you can realize the full power of compound interest. So what is the big deal anyway about a few percentage points over time?
Does it really make a difference whether your retirement account earns 8%, 10%, or 15% a year?

YES, YES, YES! It matters! In fact this is THE most important factor you need to consider.

The Magic Formula for Building Investment Wealth: Compound Interest


You vaguely remember that Junior High School math lesson on simple and compound interest don't you? Suppose you open an account that pays a specific interest rate, compounded annually. If you make no further contributions and let compound interest work its magic the balance your account will grow to at some point in the future is known as the future value of your starting principal.
  • FV is the Future Value of your money you can calculate with this formula
  • P is the starting Principal
  • r is the rate of return expressed as a decimal (e.g., 8% is .08)
  • Y is the number of years
FV = P(1 + r)Y
The above assumes we are compounding once per year. If you want to compound n times per year, you use: FV = P(1 + r/n)Yn


Obviously you and everyone else in the world knows it is better to have a high rate of return, but have you ever paid attention to the enormous impact that compound interest has on your future financial security and happieness? 
Let's take a simple example:

Suppose you are 40 years old and have $10,000 in a self-directed IRA account. For the purpose of this example, let's assume you will never add another dollar to that account out of your own pocket. How much will that $10,000 be worth at age 65? As you can guess the answer depends drastically on your rate of return. If you were getting a 6% annual return on your investment, then in 25 years that $10,000 would turn into $42,918. How would that same amount grow with a higher rate of return? 

 At 8%, in 25 years that $10,000 would turn into $68,484..
 At 10%, in 25 years that $10,000 would turn into $108,347.
 At 15%, in 25 years that $10,000 would turn into $329,189.
 At 20%, in 25 years that $10,000 would turn into $953,962!

Think about that. Without adding a dime to that account you could turn that $10,000 into almost 1 million dollars. But who's going to give you 20% interest you say? You are. We'll let you in on a 3 little secrets,
  1. Wealthy people don't get wealthy by settling for market returns.
  2. The money managers and brokers managing your 401K and mutual funds will get paid millions of dollars from fees and commissions regardless of the return they produce for you.
  3. As an individual investor, you have advantages that the big fund managers don't have. Once you understand this, you can exploit these advantages
Now what would happen if you were to add a small amount of money to that account each month, how would your nest egg change then? Look at the chart below and pay special attention to the columns with the higher rates of return. 

Monthly addition6% interest Over 25 years8% interest Over 25 years10% interest Over 25 years15% interest Over 25 years20% interest Over 25 years
$0 (no monthly contribution)$42,918$68,484$108,347$329,189$953,962
$50$ 77,647$115,564$172,764$474,420$1,289,068

Take Control of your Future

"Proverb: He who fears something gives it power over him"

So how do you consistently get that 15-20% return with almost no risk? You need to manage a portion of your future for yourself.
It is not that difficult once you learn how, but most people won't get started because of fear. Fear that they will lose money. Fear that they will not be able to do as well as the market. 

The greater risk is *not* taking some responsibility for your own future. "But I can't beat the market", you say. As we'll explain that's the wrong yardstick to begin with. You don't want to beat the market, you want to earn a consistent level of return each year. If the market looses 8% one year, who wants to "beat the market" by losing only 5% that year? Not us. And hopefully not you. We want to earn at least 15% on our retirement investment. So why are we sharing this information? 

Let's put it this way. We're advocates for the little guy. There are a lot of people in the financial services industry that want to manage our money because that is how they make money. They don't necessarily want us to know what they know, because then we wouldn't need them. Luckily for them, there are many investing myths out there that keep us in check. We accept these myths as truths, and that keeps us from taking action. 

We're not suggesting that you try to manage your entire retirement nest egg yourself. At least not immediately. Rather think of it as a new definiton of diversification. To start, leave the majority of your funds with your current 401K or IRA, but move a small percentage, maybe 10-20% to a self-directed IRA account. Get started today! 

"Never be afraid to try something new.
Remember, amateurs built the ark, professionals built the Titanic."

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