From Piggy Bank to Pension
Time is the most powerful weapon in an investor's arsenal. Nothing comes close to it.
By James K. Glassman, Contributing Editor
From Kiplinger's Personal Finance magazine, February 2006
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But enough numbers. If you're a young person, all you need to know is that you must start early. If you are an older person who has young progeny or young friends, encourage them to start early. If you're particularly generous, set up a long-term trust or a Section 529 tax-advantaged college savings plan, or simply open a mutual fund account that the young person promises not to touch (or perhaps doesn't know anything about).
The next step is deciding what to put into the account. What is the best investment for the next 40 or 50 years? No one can be certain what the world will look like in 2050, but here are some modest assumptions.
First, for the U.S. economy and U.S. companies, the future will look pretty much like the past. We can expect stock-market values to rise at roughly the same rate as they have over two centuries, a little more than 10% annually, on average. Second, the power of Òcreative destruction,Ó as the economist Joseph Schumpeter described the capitalist process, will lead to the decline, merger or bankruptcy of many companies that are currently flourishing.
Third, more revenues don't necessarily mean a higher stock price. The financial guru Benjamin Graham understood this well. Right after World War II, he predicted a boom in the use of commercial airlines, but warned that copious passenger miles might not necessarily translate into copious profits. He was right.
Fourth, globalization will increase opportunities for investment outside the U.S. And fifth, the greatest risk to the buying power of a nest egg will be inflation.
Add three more verities, and you have the basis for devising an ultra-long-term strategy for investing for retirement: Keep expenses low, watch out for taxes and diversify.
Where to invest. A simple but effective portfolio that meets these criteria might look like this: half of your savings in large U.S. companies, held in a managed mutual fund with minimal expenses or in an index or exchange-traded fund; 20% in small U.S. companies, held similarly; and 30% in international stocks, in managed or index funds or ETFs.
What, no bonds? Since 1926, according to the Ibbotson Associates data series, long-term U.S. government bonds have returned an annualized 5% or so, corporate bonds 6%, and stocks, as mentioned, 10%. After subtracting for inflation, the differences are even more striking: Bonds return between 2% and 3%, stocks 7%. A dollar invested in large-company stocks in 1926 grew to be worth $239 in buying power (that is, after inflation) by 2004. A dollar invested in Treasury bonds grew to just $6 in buying power. The only reason to invest in bonds is to dampen risk. Although bonds exhibit far less volatility in the short term than stocks, in the long term, bonds are just as risky as stocks, mainly because bonds are more exposed to the ravages of inflation.
And when you construct a Start Young Retirement Portfolio (which I'll christen SYRP, like the stuff you pour on pancakes), you have vast stretches of time in front of you -- 30 years or more. Even for 20-year periods, stocks have been less risky than bonds. The Ibbotson figures show that since 1926, the worst rolling 20-year period for large-company stocks (1926-1945, 1927-1946 and so on) produced average annual returns of 1.4% after inflation, which is only about one percentage point below the average return for bonds for all 20-year periods. The worst 20-year period for bonds? An annualized loss of 3.2%. For the SYRP investor, bonds stink.
Volatility, however, is worrisome only if you might have to liquidate your investment. When you get into your fifties, you can start moving assets that you hold in tax-deferred accounts from stocks to bonds. In taxable accounts, simply devote your new contributions to bonds and leave the stocks alone, to build up capital gains.
Which brings up the final point: Pay attention to tax consequences. With tax-deferred plans, such as 401(k)s, 403(b)s and IRAs, capital gains and dividends build up tax-free (and should be automatically reinvested). But even a taxable SYRP doesn't have to generate much in the way of taxes if it's invested in a mutual fund such as Jensen Portfolio (symbol JENSX). Jensen has an average annual turnover rate of just 9%, an indication that a typical stock is held for about 12 years. (The lower the turnover, the lower the tax bill.) The fund has a very reasonable expense ratio of 0.85%, and over both the past five and ten years it ranked in the top 10% of funds buying large, growing companies.
Of course, you can control turnover and taxes best if you manage a portfolio of individual stocks yourself. Be my guest, but recognize that you'll have to pay attention to your holdings and make adjustments to your SYRP. Just remember that the key is to pour it on. Now!