Investment Articles

 

• Teaching Teens About the Power of Compounding
  
• Steps to Keep the Next Bernie Madoff Away From Your Assets
  
• The Hidden Cost of Mutual Funds
  
• Managing Risk with Asset Allocation
  
• Protecting Your 401(k) Savings

 

Teaching Teens about the “Power of Compounding”

It’s never too soon to start saving for retirement. The earlier they start saving, the more time their money has to grow. And the teen years are a great time to teach our kids about the importance of saving money. A big challenge many parents have is getting their teenagers interested in saving money. Let’s face it, when you’re in your teens, the last thing you’re thinking about is saving for retirement. If you tell them they should start putting something away for retirement, their response will probably sound something like; “why do I need to start saving now, I'm only 17 years old. I won't be retiring for another 40 or 50 years. I have plenty of time."

Motivating a teen to save for retirement may be a difficult task, but that's not to say it can't be done.

When I talk to kids in schools, one of my favorite topics to help initiate a conversation about the power of compounding is the classic “doubling of penny”. When I was recently invited to speak at one of my son’s classes at Groton Dunstable High School, I asked them to each take out a sheet of paper and write down their answer to the following question. If you have a penny and it doubles in value each day, how much money would you have at the end of one month (31 days)? Their answers ranged anywhere between $10 and $1,000. Needless to say, they were speechless when I showed them a chart demonstrating how the penny ends up being worth more than; “ten million dollars.”

Day 1                           $.01
Day 2                           $.02
Day 3                           $.04
Day 4                           $.08
Day 5                           $.16
Day 6                           $.32
Day 7                           $.64
Day 8                           $1.28
Day 9                           $2.56
Day 10                          $5.12
Day 11                          $10.24
Day 12                          $20.48
Day 13                          $40.96
Day 14                          $81.92
Day 15                          $163.84
Day 16                          $327.68
Day 17                          $655.36
Day 18                          $1,310.72
Day 19                          $2,621.44
Day 20                          $5,242.88
Day 21                          $10,485.76
Day 22                          $20,971.52
Day 23                          $41, 943.04
Day 24                          $83,886.08
Day 25                          $167,772.16
Day 26                          $335,544.32
Day 27                          $671,088.64
Day 28                          $1,342,177.28
Day 29                          $2,684,354.56
Day 30                          $5,368,709.12
Day 31                          $10,734,418.24

Of course, no investment doubles daily, but it is an eye opening way of introducing this important concept. The second and more realistic example illustrates how saving less money now, rather than saving more money later, can significantly increase their chances of retiring with more than one million dollars.

Matt and Danny are twenty years old. Danny has read about the benefits of saving early for retirement, so he decides to start saving $2,000 into a Roth IRA every year for ten years. At age 29, he stopped putting money into his IRA. Matt decided to wait to start saving for retirement until he turned 30 years old. He then invests $2,000 into a Roth-IRA every year until he turned 65. Danny and Matts investments both earned an average return of 10 percent. When Matt and Danny turned 65, who do you think ended up with more money, Danny who invested $20,000 or Matt who invested a total of $72,000? The accompanying chart shows that Danny came out ahead by $425,000! How it that possible? Danny may have invested less money, but he also started saving ten years earlier than Matt.

The power of compounding turned Danny’s $20,000 of savings
into more than $1 million!

Current Age	Danny Invests	Ending Balance	Matt Invests	Ending Balance
20	$2,000	$2,200	$0	$0
21	$2,000	$4,620	$0	$0
22	$2,000	$7,282	$0	$0
23	$2,000	$10,210	$0	$0
24	$2,000	$13,431	$0	$0
25	$2,000	$16,974	$0	$0
26	$2,000	$20,871	$0	$0
27	$2,000	$25,158	$0	$0
28	$2,000	$29,874	$0	$0
29	$2,000	$35,062	$0	$0
30	$0	$38,568	$2,000	$2,200
31	$0	$42,425	$2,000	$4,620
32	$0	$46,667	$2,000	$7,282
33	$0	$51,334	$2,000	$10,210
34	$0	$56,467	$2,000	$13,431
35	$0	$62,114	$2,000	$16,974
36	$0	$68,325	$2,000	$20,871
37	$0	$75,158	$2,000	$25,158
38	$0	$82,674	$2,000	$29,874
39	$0	$90,941	$2,000	$35,062
40	$0	$100,035	$2,000	$40,768
41	$0	$110,039	$2,000	$47,045
42	$0	$121,043	$2,000	$53,949
43	$0	$133,147	$2,000	$61,544
44	$0	$146,462	$2,000	$69,899
45	$0	$161,108	$2,000	$79,089
46	$0	$177,219	$2,000	$89,198
47	$0	$194,941	$2,000	$100,318
48	$0	$214,436	$2,000	$112,550
49	$0	$235,879	$2,000	$126,005
50	$0	$259,467	$2,000	$140,805
51	$0	$285,414	$2,000	$157,086
52	$0	$313,955	$2,000	$174,994
53	$0	$345,351	$2,000	$194,694
54	$0	$379,886	$2,000	$216,363
55	$0	$417,875	$2,000	$240,199
56	$0	$459,662	$2,000	$266,419
57	$0	$505,628	$2,000	$295,261
58	$0	$556,191	$2,000	$326,988
59	$0	$611,810	$2,000	$361,886
60	$0	$672,992	$2,000	$400,275
61	$0	$740,291	$2,000	$442,503
62	$0	$814,320	$2,000	$488,953
63	$0	$895,752	$2,000	$540,048
64	$0	$985,327	$2,000	$596,253
65	$0	$1,083,860	$2,000	$658,079

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Granted, one million dollars will not be enough money to retire on in 40 or 50 years from now, but this example is also meant as way of demonstrating to teenagers that saving money, earlier rather than later, can increase their chances of having a substantial amount of savings in retirement. One of the best things we can do for our kids is getting them to start saving money early in life. The earlier they start, the more time compounding has to work in their favor, and the wealthier they can become. Once teens can see the actual impact that the combination of time and compounding can have, saving money can suddenly become very exciting. 

 

5 Steps to Keep the Next Bernie Madoff
Away From Your Assets 

Friday, June 29th marked the three-year anniversary when Bernie Madoff, president of Madoff Investment Securities was sentenced to 150 years in prison for swindling more than 4,800 clients out of $65 billion. It was the single largest case of fraud in U.S. history. Some of Madoffs more famous victims included; Steven Spielberg, Kevin Bacon, Hall of fame pitcher Sandy Koufax, Larry King, Zsa Zsa Gabor, and World Trade Center developer Larry Silverstein.

Determining whom to trust with your money isn't easy. Today there are financial advisors everywhere you look. Banks, brokerage firms, insurance agencies, credit unions, and accounting firms all seem to offer financial advice. According to the U.S. Bureau of Labor Statistics, there are nearly 176,000 people out there calling themselves financial advisers.

Selecting someone who is being paid to provide you with investment advice is a crucial decision. One of the best ways to avoid becoming the next victim of investment fraud is to know what it looks like so that you recognize it when you see it. The following are 5 issues to be aware of and steps to take to avoid becoming the target of financial fraud.

1. Never work with an advisor who doesn’t explain how your money will be invested. Bernie Madoff made it very clear to investors that he did not like questions regarding his investing techniques. He wouldn't share much detail about his investment strategy with potential investors, claiming he had to keep it a secret to maintain his advantage. He would often fire clients requesting information how their money was invested.
   
2. Beware of any financial advisor who promises above average returns. Promises of high returns, with little or no risk, are classic warning signs for fraud. Madoff promised investors a steady return of double digit returns on their investments, year in and year out, regardless of the state of the stock market or the global economy. The truth is that no one can consistently achieve above average returns, not even Warren Buffet. Over the last three years, the stock market (measured by the S&P 500) has out performed Buffets Berkshire Hathaway by 15%.
   
3. Beware of any financial advi­sor who asks you to make your investment checks payable to him or his firm. The only check you should make payable to an advi­sor is for his or her management fee. Any check you write to invest funds into your account should be made payable to an outside custodian (i.e., a bro­ker­age firm such as Schwab, or mutual fund company such as Fidelity or Vanguard) handling your account. With a custodian, the investment assets are held in an account separate from the financial advisor, and in your name only. Your advisor will have the authority to make investment transactions on your behalf, but it is the custodian that actually has possession, or custody, of your assets. Bernie Madoff acted as both financial advisor and custodian of assets. His clients made their investment checks payable to his firm, Bernard L. Madoff Investment Securities. As a result, Madoff created false account statements about the returns his clients were receiving.
   
4. Never work with an advisor without a written and signed contract specifying the services to be rendered, the cost of those services, and how the advisor will be compensated. Madoff verbally told clients that the fee for his services would be a commission of only $0.04 per share on the stocks that he traded.
   

1. Always look at your statements. A custodian holding your assets will send monthly or quarterly statements. They are required to report all activity in your account directly to you. Your financial advisor may also send you performance reports or account statements. These reports can now be compared with the custodian’s. If Madoffs clients received quarterly statements from an outside custodian, they would have known that the financial statements they were receiving from him were fabricated. 

Trust is important when dealing with a financial advisor, but blind trust can be abused. You want to make sure that the adviser you select is working in your best interest and that your retirement savings are protected.

 

The Hidden Cost of Mutual Funds

In selecting mutual funds, the expense ratio is frequently the only cost that many investors believe they pay when owning a mutual fund. The expense ratio is the annual fee that all funds charge their shareholders. It expresses the percentage of assets shareholders pay each year for fund expenses including; 12b-1 fees, management fees, administrative fees, and other operating costs incurred by the fund. The problem is that there are other costs not reported in the expense ratio, and those expenses can make a fund two or three times as costly as advertised. Two such expenses are sales charges and transaction costs.

Sales Charges
Many mutual funds charge a front-end sales charge upon purchase. This fee essentially serves as a commission to the broker who sold the fund to the investor. In addition, many mutual funds charge a back-end sales charge when a fund is sold.

Transactions Costs
Far and away the potential biggest cost not included in a funds expense ratio are, transaction costs. Every time a fund manager places a buy or sell order on a stock within the portfolio, he or she must pay brokerage commissions. The cost for these transactions aren’t actually paid by the fund manager, they are passed along to each of the funds shareholders. Transaction costs can be difficult to determine, as they are not found in most prospectuses. They can however be determined based on information found in the “Statement of Additional Information”, a document mutual fund companies don't generally distribute to investors, but must make available upon request.

Studies conducted by researchers at Virginia Tech and the University of Virginia found that actively managed stock mutual fund incur average trading costs of 1.4% per year. This is in addition to their 1.3% average expense ratio. By comparison, the average index funds transaction costs are only 0.20% per year. As a result, index funds have significantly lower overall expenses. Do you know how much your mutual funds are costing you each year? It’s probably a lot more than you think. The accompanying chart shows that the average mutual funds actual expense ratio, after factoring in sales charges and transactions costs is approximately six times higher than a low cost index fund.

 

	Average Mutual Fund	Average Index Fund
Expense Ratio	1.3%	0.30
Transaction costs	1.4%	0.20
Sales Charges	0.5%	None
Actual Expense Ratio	3.2%	0.50

 

 

 

 

 

How much of a difference can this make? Consider the following three examples.

1. The average actively managed stock fund incurs annual expenses of about 3.2%, or $3,200 for every $100,000 an investor has in the fund. An investor with $100,000 in an index fund with annual expenses of .50 would pay only $500.
   
2. If the stock market earned 10 percent, an index fund would return 9.5% (after expenses). The actively managed fund would return 6.8 percent. A $100,000 investment in the actively managed fund after 20 years would be worth $372,000. The same $100,000 investment in the index fund after twenty years would be worth $615,000. The additional $243,000 (65 percent) of savings in the index fund is due entirely to its lower expenses.
   
3. A fund manager in the actively managed fund would need a return of 12.8 percent (before expenses) to outperform the 9.5 return of the index fund.

The success of indexing has been well documented over the years. Due to their significantly lower overall expenses, index funds outperform approximately two out of every three actively-managed funds each year. Increase the holding period to 10 years, and index funds outperform approximately 80 percent of all actively managed funds.

 

Managing Risk with Asset Allocation

Numerous studies and Nobel Prize-winning research over the last fifty years shows that over the long term that 95 percent of a portfolios performance will be determined by its asset allocation. Only 5 percent is determined by the return of the individual investments. In other words, asset allocation will have more to do with the success or failure of your portfolio than finding the best-performing investments. How can that be? That makes absolutely no sense. After all, what matters more than having the best investments? Consider the following example. It’s 2008, and you have $100,000 to invest. You decide to invest $70,000 in the Fidelity Contrafund (4 star fund) and $30,000 in the Vanguard Total Bond Market Index Fund (3 star fund). Your asset allocation is 70 percent stocks and 30 percent bonds. For the year, the Contrafund lost 37 percent, and the Vanguard Bond Market Index Fund gained five percent. As a result, you end up with $75,600 - a loss of almost 25%. If instead you invested $70,000 in the Vanguard Total Bond Market Index Fund, and $30,000 in the Fidelity Contrafund your portfolio with an asset allocation of 70 percent bonds and 30 percent stocks would be worth $93,000, - a loss of only 7 percent. In both instances the funds in each portfolio were the same however the ending values were not. The $17,400 difference between the two portfolios was due to the difference in the asset allocation.

When it comes to investing, the goal is to increase your savings, but not at the risk of jeopardizing your lifestyle or your financial security. During my 15 years as a registered investment advisor I have always been amazed how many individuals in their fifties and sixties invest so much of their retirement savings in stocks. The statistics also back this up. According to the Employee Benefit Research Institute, over forty-percent of investors between the ages of 56 and 65 had more than 70 percent of their retirement savings in stocks into 2008. At Capital Wealth Management we believe a more prudent asset allocation should be closer to the opposite end of the risk spectrum. As a result, the majority of our client’s assets who are close to, or in retirement, are invested in a diversified multi-asset class portfolio comprised of 30 percent stocks and 70 percent bonds.

A portfolio with an asset allocation heavily weighted in stocks can expose an investor to the risk of a significant financial loss during down markets The accompany chart shows how a portfolio with an asset allocation of 70 percent stocks and 30 percent bonds, and a portfolio of 30 percent stocks and 70 percent bonds performed during each of the stock markets seven worst bear markets. The top line shows that during the Great Depression (from Sept. 1929 to July of 1932), the U.S stock market lost 86 percent. During this time, the 70/30 portfolio lost a whopping 56%, while the 30/70 portfolio lost only 16 percent. The bottom line shows that the 30/70 portfolios average loss in ten bear markets were “significantly smaller” than the U.S. stock market and 70/30 portfolio. 

Investment Period	Stock Market	70/30 Portfolio	30/70 Portfolio
Sep 1929 - Jul 1932	-86%	-56%	-16%
Mar 1937 - Apr 1942	-60%	-40%	-13%
May 1946 - Jun 1949	-30%	-19%	-4%
Dec 1961 - Jun 1962	-28%	-17%	-2%
Feb 1966 - Oct 1966	-22%	-14%	-3%
Jan 1973 - Oct 1974	-48%	-31%	-8%
Nov 1980 - Aug 1982	-17%	-5%	+11%
Jul   1990 - Oct 1990	-19%	-12%	-2%
Apr  2000 - Mar 2003	-43%	-19%	+13%
Oct  2007 - Mar 2009	-57%	-37%	-11%
Average Loss	-41%	-25%	-4%

 

 

 

 

 

 

 

 

 

 

 

 

Stocks: Dow Jones Index from 1929 to 1966; S&P 500 Index from

1973 – 2010. Bonds: Intermediate Term U.S. Treasury Bonds

Investors who use effective risk management strategies increase their odds of earning acceptable returns in both up and down markets. From 1926-2011 the 70/30 portfolio earned an average return of 8.4 percent. The 30/70 portfolio achieved an average return of 7.0 percent. Put another way, the 30/70 portfolio earned nearly 85 percent of the return of the 70/30 portfolio return while taking significantly less risk.

 

Protecting Your 401(k) Savings

"If a 401K plan has been abandoned, it is extremely difficult for an individual participant to actually get access to his account." Virginia Smith, Director of Employee Benefits U.S. Department of Labor

When you are working for a company, participating in its 401(k) plan with high contribution limits, tax deferred growth, upfront tax deductions, and a company match is a great way to save for retirement. But what do you do with your 401(k) when you move to your next job? Most individuals often make one of two mistakes; they cash it out, or they leave it in their former employers plan.

Mistake #1 - Cash it out
Cashing out a 401k is never a good idea. When you take money out you have to pay federal income taxes; and a 10 percent penalty if you are under the age of fifty-nine and a half. For example; A 50 year old in the 28 percent tax bracket, chooses to cash out his 401(k) worth $500,000. After paying $140,000 in taxes, and $50,000 in penalties, he is left with $310,000. Taking this cash distribution has reduced his retirement savings by 39%.

Mistake #2 – Leave it behind
At first blush, there is little reason to not leave a 401(k) plan with an old employer. Leaving money in a former employers plan is easy to do. There are no forms to fill out, and no additional investment decisions to make. You won’t be assessed any taxes or penalties, and your money can continue to grow tax deferred. There are however, two disadvantages of leaving money in a former employers plan. One is high fees. Every year thousands of people leave money sitting in their former employers plan without having any idea how much it costs them. According to a study by Deloitte Consulting, the average cost for a company 401k plan is 1.25%. An individual with $500,000 in 401k plan with a cost 1.25% would pay more than $140,000 in fees over 20 years.

The second and potentially bigger disadvantage is the risk of losing track of your 401k. If a former employer gets bought out, shuts it doors, or declares bankruptcy, the 401k plan for that company can become “orphaned”. An orphaned plan is one where the sponsor and fiduciary have abandoned the plan. The money in an orphaned plan is not actually lost; it is still there, but without a fiduciary and sponsor any longer overseeing the plan, the money cannot be distributed to its employees. The Department of Labor estimates there are at least 15,000 orphaned company plans each year. Since 2007, the number of businesses filing for bankruptcy has risen 46 percent.

The most effective way to avoid the risk of this ever happening is to roll a 401k into an IRA.  Once you roll your 401k savings into an IRA, your former employers problems are no longer your problems. A rollover IRA allows you to have complete control of your retirement savings. A rollover IRA also provides additional advantages over a 401k:

Penalty Free Withdrawals
The IRS allows for penalty-free withdrawals from an IRA to pay college tuition for yourself, a spouse, children or grandchildren, or to pay health insurance premiums if you are unemployed, including COBRA premiums. You can also withdraw up to $10,000 penalty-free to put toward the purchase of a home.

More Investment choices
Rather than being limited to the number of funds within an employers plan, rolling your 401k into an IRA gives you access to more than 15,000 mutual funds to choose from.

Simpler Distribution Rules
There is one set of IRS rules governing required minimum distributions at age 701/2 for rollover IRA’s and another set of rules for 401k plans. If you have multiple IRA accounts, you can add up the value of all your IRAs and take the required distribution amount from any one of the accounts. If you have multiple 401(k) accounts, you must calculate the required distribution amount for each 401(k) separately and then withdraw the required amount from each account. The failure to take a distribution from a rollover IRA or 401k will result in a 50 percent penalty of the difference between the required minimum distribution and the amount you actually withdrew.

Peace of Mind
The odds of your 401k becoming lost or abandoned may be small, but it is a possibility. Imagine what it would be like if you couldn't access your 401(k) savings when it comes time to retire? Rolling your 401k into an IRA will make sure that the retirement savings you need, will be there when you need it in retirement.

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