Download Appreciating Assets Part 1: Stocks and Bonds

Appreciating Assets Part 1: Stocks and Bonds
by David John Marotta | 04-05-2010
All assets are not equal. Some investments appreciate better on average than others. If you have $100,000 saved toward your retirement, how you
invest it can make a difference in the likelihood and standard of living of your retirement.
Let's look at various investments over a 25-year time horizon. That span of time could be before retirement, say from age 40 to 65. Or it could be
your retirement years from age 65 to 90.
We begin with equities, shares of stock in companies that earn a profit and grow their business. Equities could be individual stocks, stock mutual
funds or exchange-traded funds (ETFs). On average, equity investments appreciate at a rate of 6.5% over inflation.
In the United States, inflation has been higher since 1970. It has also
been officially underreported since 1996 when the government
You should not put a large portion of your assets in
fixed-income investments over 25 years.
changed the way it calculates the Consumer Price Index (CPI). This
lowered the official inflation figures by about 2% a year. But for the
purposes of this article, I assume inflation is a constant 4.5%.
The stock market averages between 10% and 12% a year. But the annual return almost never falls in that range. Just look at the returns of the prior
five years: 4.9%, 15.8%, 5.5%, -37.0%, and 26.5%. None of these fell even close to the 10% to 12% average.
This return comes partly from a 4.5% annual inflation and partly from a 6.5% real return over inflation. Add those two components together, and you
get an average 11% return. When inflation runs higher than 4.5%, you may get a higher return, but you won't get increased purchasing power. In
fact, all you will get is taxed on the larger capital gains caused by inflation.
The appreciation of equities produces an engine of growth. Over our 25-year period at 11% growth, our $100,000 initial investment grows to over
$1.3 million. At this rate of return, our investment doubles every six years.
Two important reminders: First, equity markets don't provide a smooth return. Pick any 10 years over a century, and 6% of the time you will find
returns that are zero or have losses in the S&P 500. Diversification helps, but the equity markets are inherently volatile, especially in the short term.
Second, the $1.3 million you end up with only has the buying power of about $483,000. Inflation eats the other $875,000. You also have to pay
capital gains on the entire $1.2 million growth. With Congress raising the capital gains tax from 15% to 20% or even 25% because health care reform
has passed, it hardly seems worth all the risk. But as we will see, the alternatives are worse. Economically, the capital gains tax should be zero. It
would certainly produce more jobs than taxing business to pay for extending subsidies of people not working and calling it a jobs bill.
When planning with clients, I've found it much better to factor out inflation and not use inflated numbers. It is difficult to hear $1.3 million and
mentally translate into the equivalent in today's dollars. So let's use a 6.5% real return and compare against our $100,000 growing into $483,000
over 25 years.
Some equities, although more volatile, can boost returns even higher. Mid-cap and small-cap stocks average higher returns. So do value stocks and
emerging market stocks. If small-cap value stocks averaged 8.5% over inflation, your initial $100,000 would grow to a buying power of $769,000.
And history suggests the small-cap value growth rate is even higher.
Equities are the engine of your retirement savings. Most of your savings should be invested to take advantage of this appreciation. Even in
retirement, you need enough appreciation to keep up with inflation, pay the taxes and still have some real return left over.
The second largest portion of a good investment plan should be in stable assets such as fixed income. Fixed-income investments are most commonly
bonds: individual bonds, bond mutual funds or bond ETFs. A stock means you own a piece of the company. A bond means you have loaned the
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company money, and it has promised to pay you back with interest. If the company goes bankrupt, you may not get your money back. And if the
company does incredibly well, you will not have a share in that good fortune. The most you will get is what you put in plus the agreed-on interest.
Fixed-income investments are much more stable than equity investments. On average, however, they only earn about 3% over inflation. With
inflation at 4.5%, fixed-income investments should be paying about 7.5% on average. With the Federal Reserve holding interest rates low,
fixed-income investments currently are earning below their historical averages.
Your $100,000 investment earning a 3% real return would grow to a buying power of just $209,000 over 25 years. Again, although you might have
$609,000, you would only have the buying power of $209,000. And you would have had to pay ordinary income taxes on the $400,000 of interest
that just kept up with inflation.
But you should not tie a large portion of your assets up in fixed-income investments over 25 years. We recommend only having the next five to
seven years of safe spending rates in fixed income were you to retire today.
At age 65, this strategy would allocate about 25% to stable fixed income and the remaining 75% of investable assets to appreciating equity
investments. This is a higher equity allocation than many agents would suggest. They will earn their fee just as well off a bond fund as an equity fund.
And they have found that investors don't notice the high fees as much if they have a lot in stability.
They might allocate 40% or 50% to fixed income instead of just 25%. But this reduces your return. Stocks average 6.5% over inflation. Bonds
average 3% over inflation. Any mix between the two provides a blended return. So a 50-50 allocation has a 4.75% average return. And a 75-25
portfolio averages a 5.625% return.
Your average real return is this percentage minus the expense ratio charged by your investments. With low expense ratio investments from
Vanguard or iShares, your expense ratio should be around 0.4%. Typical mutual fund selections have average expense ratios of 1% or more. The
average 401(k) plan has even higher expense ratios.
So a 50-50 allocation from an agent selling funds with an average expense ratio of 1.2% produces an expected real return of only 3.55%. But a 75-25
allocation with an average expense ratio of 0.4% produces an expected real return of 5.62%. In our 25-year case study, your $100,000 portfolio only
grows to have the buying power of $239,000 in the conservative portfolio with higher fees. And in the other case, it grows to $392,000. Those who
combine playing it safe but suffering higher expense ratios retire on average with a lifestyle of only 61% as much.
The top-level asset allocation decision determines both the ultimate return you will receive and the volatility you will experience. Your investments
should be working for you. They should appreciate more than inflation in order to be an engine of growth that pays you money and provides some
measure of financial freedom. A combination of stocks and bonds with low expense ratios and a tilt toward stocks provides the best tuned engine of
growth.
Marotta Wealth Mangagement, Inc. of Charlottesville provides fee-only financial planning and asset management. Visit www.emarotta.com for more
information. Questions to be answered in the column should be sent to [email protected] or Marotta Wealth Management, Inc., 1000 Ednam
Center, Charlottesville, VA 22903-4615.
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