Invest like Einstein
Reprinted courtesy of MarketWatch.com
Published: Nov. 19, 2012
To read the original article click here
Albert Einstein once described compound interest as the greatest invention of mankind. Smart investors put Einstein’s insight to work for them.
These days, many unsophisticated investors seem to thumb their noses at Einstein as they engage in a mad quest for safety above all else. Ironically, they may wind up later with less security instead of more.
Yes, you can choose safe, “guaranteed” investments for your 401(k). But you’ll most likely be stuck with returns of only 3% to 4% — just enough to keep you ahead of the long-term historical rate of inflation. To have a comfortable retirement at that rate, you’ll have to save much more money while you’re working.
Einstein’s work revolved around numbers, and I’m going to throw out a few. Over a lifetime, an increase of just two percentage points of return is stunningly dramatic, as I pointed out in several tables that are part of my 2012 book First Time Investor. Here’s a sample.
Many young investors can save $5,000 a year, the current maximum for funding an IRA. To illustrate Einstein’s genius, I calculated the hypothetical results of doing that for 40 years, for instance from age 25 to 64, at various rates of return.
An investor who gets a low-risk return of 4% could wind up with $475,128 after 40 years. But if his long-term return were 6% instead, he could have $773,810.
Think about the difference between those two numbers: $298,682. Over the years, this investor made 40 investments of $5,000, for a total of $200,000. Boosting his return by two percentage points — which should not be particularly difficult or risky — adds nearly 1.5 times the investor’s entire lifetime contributions to his retirement nest egg.
As Einstein would instantly notice, one small change has a huge cumulative effect. And that’s only the start.
Financial planners teach that it’s possible to safely withdraw 4% of a portfolio’s value annually in retirement. Applying this rule of thumb, the investor who achieved 4% could take out $19,005 in his first year of retirement. The one who earned 6% could take out $30,952. That makes a huge change in the investor’s retirement lifestyle.
There’s more: If you assume the same investment return continues for 30 years of retirement, the portfolio can grow even while it’s paying out retirement income. With a 4% return every year for 30 years, you can take out a total of $557,121; at 6%, your lifetime withdrawals become $1,209,551.
It’s even better than that. After 40 years of savings and 30 years of retirement, the investor who got a 4% return would have $452,843 to leave to his heirs. The investor who got 6% would have more than three times that much: $1,306,012.
To recap: At 4%, your $200,000 of lifetime savings gives you $557,121 in retirement plus $452,843 after 30 years. At 6%, the same $200,000 contributions give you $1,209,551 in retirement plus $1,306,012 after 30 years.
The totals: At 4%, $200,000 of savings produces a little more than $1 million in total benefits. At 6%, the total benefits are about $2.5 million. It doesn’t take an Einstein to see why this is worth thinking about.
An obvious question is how to obtain the higher return. While nothing – and I really mean nothing – is guaranteed, the long-term history of investment returns shows that you don’t have to take much additional risk to boost your expected returns from 4% to 6%. Going from all-fixed-income to a 20% or 30% equity position is likely to do the job – with very little extra risk.
You can increase your returns in other ways as well. Keep your expenses low, ideally by using index funds or exchange-traded funds. Diversify beyond the Standard & Poor’s 500 Index SPX, +0.08% by including funds that invest in small-cap stocks, value stocks, small-cap value stocks, international stocks, emerging markets stocks and real estate investment trusts.
All these investments are readily available in funds I recommend at Vanguard and Fidelity.
Finally, if you’re interested in notching up the returns even more, consider the results of achieving a long-term return of 8%. At that rate, the same $5,000 a year of savings would grow to $1,295,282 after 40 years, producing a first-year retirement income of $51,811, total retirement distributions of $2,755,274 and leaving $3,830,134 after 30 years.
If you can achieve that, your family and your heirs might think you were as smart as Einstein.
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