Total Wealth by Mac Barnes with intro by Michael Bloomberg Click here to return to book details CHAPTER 1 Accumulating a million dollars Want to accumulate a million dollars in your lifetime? Would you like to give each of your children one million dollars? What you are about to read will change the way you accumulate wealth. With this information you can begin to accumulate wealth optimally. This will become the benchmark by which you judge all future investments. This chapter will give you a quick overview. Pillar 1: Compound Returns The first pillar of personal wealth is compounded returns on your investment. $10,000 invested at 14% for thirty-five years becomes $1,280,000. Now, 14% is interesting for two reasons. First your money doubles every five years if it is invested at 14%. That means in five years $10,000 becomes $20,000, and after five more years (total: ten years) it becomes $40,000, and so on ($80,000, $160,000, $320,000, $640,000) until it reaches $1,280,000 after thirty-five years. And all that without adding a single penny to your original $10,000. The second interesting thing about 14% is that it is close to the return on common stocks for the past twenty years. We are using the S&P 500 Stock Index as a proxy for the stock market. As of 10/31/00, the exact returns have been: S&P 500 stock index return over the past 3 years 17.58% S&P 500 stock index return over the past 5 years 21.64% S&P 500 stock index return over the past 10 years 19.40% S&P 500 stock index return over the past 15 years 17.47% S&P 500 stock index return over the past 20 years 16.51% Therefore, you can see that 14% was a rate of return that you could have earned if your $10,000 had been invested in the S&P 500 Index. Pillar 2: Asset Allocation Can you keep all that money compounding for thirty-five years? Yes, you can, but most of us do not. Why? Because as soon as the refrigerator breaks we raid the savings account, and out goes our compound returns. The solution to this problem is to have two accounts. Let’s call one your savings account, and you use it like most of us use our savings account: to save for a house or a car or to pay an unexpected bill. We will always need those savings dollars. The second account we will call our Personal Endowment Account (PEA), and we never withdraw from that account. The money we put into the Personal Endowment Account we will never expect to spend. Of course, if we need it when we retire, we can use it, or if we experience a major disaster, we may resort to it. But if we are healthy and prosperous for the rest of our life, then we will leave it to our heirs. That’s right; following this plan you will save a million dollars and never spend it in your lifetime, but you will be personally wealthy. Did anyone ever tell you, "You can’t have your cake and eat it too"? Therefore, any money we put into the Personal Endowment Account will remain there for our entire life, earning compound returns. This is pillar number two. Fear not: Having a million without spending it does not mean that you can’t enjoy life. How would you like to be well endowed? The lifestyle of a dowager could be yours. That simply means that your wealth grows faster than your expenses. We usually think of a dowager as an old rich widow living off her late husband’s estate. But let’s think of young, happy people living off their own personal endowments. Pillar 3: Index Funds In 1973 a Princeton University economics professor, Burton G. Malkiel, wrote A Random Walk Down Wall Street, in which he proposed that the market averages would over time outperform active market participants. This is because Malkiel believes that markets are basically efficient. If markets are efficient, then people who try to beat the market will lose for two reasons: first, because trading generates high transaction costs, while following the market averages entails minimum transaction costs; second, and more important, active investors are frequently wrong, and their losses reduce their returns to below the average. It is very difficult to beat an efficient market. In the same year one of the fathers of value investing, Benjamin Graham, said the same thing in his classic book, The Intelligent Investor. "Since anyone-by just buying and holding a representative list-can equal the performance of the market averages, it would seem a comparatively simple matter to ‘beat the averages’; but as a matter of fact the proportion of smart people who try this and fail is surprisingly large. Even the majority of investment funds, with all their experienced personnel, have not performed so well over the years as has the general market."2 Perhaps as a result of these ideas, the Vanguard Index Trust 500 Portfolio was started in July 1976. This no-load mutual fund matches the S&P 500 Index. Over the past fifteen years, this fund has outperformed 86% of all equity mutual funds. Their annual fees are very low (0.18%) compared to most funds (average fees, 1.66%) because they make no investment decisions; they just mimic the S&P 500 Index. This index fund has a very low turnover; therefore, investors do not receive large taxable capital gains distributions. Vanguard Index Trust 500 Portfolio (VFINX) Total Return and Performance Ranking versus all other equity mutual funds Total Return Percentile Ranking among All Equity Funds 3-year return 17.63% top 28% 5-year return 21.64% top 18% 10-year return 19.32% top 25% 15-year return 17.28% top 14% Source: Morningstar, 10/31/00 These results, while impressive, do not include taxes. When we look at after-tax returns, the index fund outperforms even more mutual funds. Recently, Professor Malkiel told the Bloomberg Forum, "You will make money forgetting all the advice of Wall Street analysts and investing instead in equity index funds. Not can but will." Now, this professor has a track record to substantiate his theory. "What’s amazing to me is how well it works," Malkiel says. The basic tenet remains the same as in 1973: public markets are innately efficient, so there’s little point in trying to outguess them. Now, consider the implications of this. Could we find a mutual fund that did better than the S&P 500 Index over the past fifteen years? Yes, but only 14% of equity mutual funds outperformed the S&P 500 Index; 86% underperformed the index. And we have the advantage of looking back in time. But, Burton Malkiel and Benjamin Graham said that the S&P 500 would outperform most mutual funds before it happened. Now, can we pick the mutual funds that will outperform the market for the next fifteen years? That is more difficult. But if we believe that the stock market is innately efficient, then, if we pick the market average, we can expect to beat over 80% of the mutual funds in the next fifteen years. And we can make that prediction in advance and expect never to have to change our mind. Therefore, using index funds is our third pillar. What does the S&P 500 Index consist of? It is the 500 leading companies in the United States. Therefore, we have invested in a diversified portfolio of the most successful companies. And since at any time in the future it will still be the 500 leading companies, we will never have a reason to change our mind. Pillar 4: Deferring Taxes Consider the tax cost to us of changing our mind. Let us suppose that we select a terrific mutual fund which performs well for fifteen years, and our $10,000 investment has become $80,000. But now our mutual fund is underperforming, and we decide to switch to another fund. When we sell the fund, our cost basis is $10,000, and we owe tax on a $70,000 capital gain. If capital gains are taxed at 20%, that is a $14,000 tax, leaving us only $56,000 to reinvest in the new mutual fund. You can see that we will never get to a million if we have to pay taxes every time we switch investments. But if we buy an S&P 500 Index fund, we will never need to switch; it is an investment that we can live with, and it will accumulate tax deferred because we never sell it. When we arrive at one million, our original investment is still $10,000. Therefore, by never switching funds we accumulate compound returns without paying capital gains taxes. We exaggerated when we said you would "never" accumulate a million if you had to pay capital gains taxes when you switch investments. But how much will those taxes cost you? It depends on how many times you switch. But let’s say you are following a similar plan, and every ten years you decide to switch mutual funds and therefore realize your accumulated gains and have to pay capital gains taxes. After thirty-five years you would have accumulated $631,090 instead of the $1,280,000 you would have accumulated if you had not switched funds every ten years. Most people, moreover, trade their investments more often than once every ten years. When you switch investments, you pay the tax, and this reduces total return (unless you are using an IRA or Keogh account). The deferral of capital gains taxes is our fourth pillar. Also, suppose you switch investments because the fund or stock that you own is not beating the market. Since you are going to pay a significant capital gains tax if you sell a fund that has accumulated in value, most people wait to see if their fund will revive. This means that if your fund is underperforming, you will wait to see if it will start going up again. Finally, you bite the bullet and sell it. But in the meantime you have allowed an underperforming fund or stock to stay in your portfolio longer than you would have liked. Therefore, the most dangerous part of investing is switching investments: first, because it causes a tax bite; second, because we tend to hold on to losing investments; third, because we can’t predict the future and don’t really know what to buy next. Not to mention a fourth problem, which is that we must pay attention to the market and the condition of our portfolio at all times. Investing in index funds eliminates all four of these problems. Combining Pillars 1 to 4 Can one earn superior returns by investing in the market average? Common intuition suggests that the market average beats only half of the market participants. But we have suggested that the market average will beat more than half. In addition, expenses and annual taxes are lower on the average index fund. Also, we can defer long-term capital gains taxes by limiting our trading. What is the combined result of all these advantages? This chart compares the after-tax and after-expense returns from investing for ten years in 363 equity mutual funds to similar returns from investing in an S&P 500 Index mutual fund. The vertical line in the center is the return on the S&P 500 Index funds; the distribution of equity mutual fund returns above and below the index fund returns comprise the black bars. For example, the bar immediately to the left of the heavy vertical line, "-2%" with the number "19" above it, indicates that nineteen equity mutual funds earned between 0% and 2% below the index fund return. We see that after expenses, annual taxes, and long-term gains, the S&P 500 Index funds beat all but twenty-six equity mutual funds (93%). Having identified a successful investment strategy, can we increase the amount of money that we put into this investment strategy? Pillar 5: The Endowment Lifestyle The endowment lifestyle is different from the save and spend lifestyle that most of us practice. We save for a car; then we spend our money. We save for a house; then we spend our money. We save to send our children to college; then we spend that money. Finally, we save to retire. Each time we spend what we save. But the endowment lifestyle keeps our savings invested. How would you like to have the compounded value of your car, your house, and your children’s college tuition in your Personal Endowment Account (PEA)? How can we compare beating the market to beating the market with an account balance that is three or five or seven times larger than we would ever accumulate with a save and spend lifestyle? In addition, the endowment lifestyle improves our investment results by increasing our investment horizon. Long-term investments in index funds are less risky and defer more taxes for a longer time. The endowment lifestyle does not cost more than what you are doing now, and you can enjoy the same cars and houses. The greatest contribution to our total wealth comes not from investing but from modifying our lifestyle. Summary In summary, we have demonstrated that $10,000 will become $1,000,000 given enough time and a good return. We suggested a separate Personal Endowment Account, from which we will never make withdrawals. We have shown that the S&P 500 Index has earned high returns, close to 14%, and after taxes and expenses has outperformed 93% of all similar mutual funds that could have been purchased. We argued that selecting the S&P 500 Index will give similar superior returns in the future. Furthermore, you will have no desire to switch out of the S&P 500 Index, which is in keeping with the long-term nature of this plan. Our strategy is to buy the index and hold it. Therefore, never selling your invested funds will defer your capital gains taxes, allowing your compound returns to accumulate. It also relieves you of having to become a market expert or having to follow the market at all times. In addition to this investment plan, the endowment lifestyle allows more dollars to remain invested. The combination of higher returns on a larger account balance for a longer investment period is phenomenal. One key to this plan is starting. If $5,000 doubles to $10,000 in five years, then $500,000 doubles to $1,000,000 in the same five years. But getting to that first half million takes some time. You don’t have to put aside $10,000 and wait thirty-five years to have one million. You could invest $5,000 and deposit $300 a month ($10/day) for twenty-five years. Or you could invest $10,000 and add $1,000 a month and have a million in eighteen years. Many people have the income, but it all gets spent on things that earn no return. We will demonstrate that the same people, with the same jobs, can enjoy the same luxuries, yet grow in total wealth. The world in which we live has changed in the past century. People live longer than ever before. Individuals may live in retirement for thirty or forty years. We expect that we will live longer than the previous generation. What if we can continue to earn compound returns past retirement age until the end of our life? When we combine an endowment lifestyle with an extended lifespan and compound returns the results are staggering. How about children or grandchildren? If this plan is started when a child is born, by the year he or she is thirty-five, he will have $1,200,000, and five years later it will be $2,400,000. At that time in his life he will not want to sell it because it will be all capital gains. Instead, he can borrow against it or just withdraw a small amount each year while the rest grows. Wouldn’t we like it if our grandparents had done this for us? What if the market goes down? This is a real life book, and we examine all the possibilities in detail. The stock market has gone down and will go down again. We will show how you can profit through the up markets and the down markets. You will learn how far the market has dropped from its highs in every decline since 1914, and how long it took to go back up. We explain market-entrance strategies to minimize the possibility of buying at a market top. You will learn how to decide how much of your money to put into the market. We will demonstrate risk so that you will see and avoid risky situations. We will also cover market-exit strategies to provide income for retirement while maximizing your total return. We will cover sheltering your future income from inflation. And we will demonstrate transactions that minimize future taxes on your PEA. Total wealth includes not only making money but spending money and living a secure, worry-free life. We identify lifestyle risks that could threaten your investment success. We suggest lifestyle choices that reduce uncertainty. We present principles that will increase your lifestyle total return. These principles of investing are not new. But combining classic investment principles with the index mutual fund brings benefits to the ordinary person that were not available in the past. You will learn how to earn high returns with low risk. To reduce the risks even more, we investigate each area where you could make a mistake. This book is not only about money; it is about educating you to manage your money correctly. We aim to give you the best education, and we will prepare you to succeed. Price: $24.95 - Click here to order from Amazon: Click here to return to book details