The power of compounding, favor for a grandkid

[masraum]

I think this is a pretty cool idea and also an effective demonstration of the power of compounding.

Turn $3,000 into $50,000,000


How time can turn $3,000 into $50 million | Paul Merriman

How time can turn $3,000 into $50 million
Reprinted courtesy of MarketWatch.com.

To read the original article click here

As hard as it may be to believe, it’s possible to turn a single $3,000 investment into $50 million in a single lifetime. I can’t say that I have done it, but I’m going to show how you could.

This is a very tall order, one that requires an entire lifetime and more than one person to carry it out. If you’re a parent or grandparent, you can do this. Someday, a child or grandchild could be very grateful that you did.

This is the fourth column in a series on compound interest, which was famously cited by Einstein as one of the wonders of the world. For worthwhile background, you may want to read the first, second and third columns in the series.

The plan I am about to describe isn’t magic. It’s a recipe with four essential ingredients:

An initial investment of $3,000
A Roth IRA
An investment that’s likely to grow at 12% over a very long time
A long lifetime (plus ample patience).
Want to try it? Here’s how, using an imaginary infant named Brendon for the example.

When Brendon is born, set aside a lump sum of $3,000. Invest it in an ETF or a mutual fund that holds small-cap value stocks. (To learn more about this check out my podcast called The Best Small-Cap-Value ETF.)

Leave the money in that asset class to grow. And grow. As soon as Brendon has taxable earned income, start contributing the money in the account to a Roth IRA in his name, keeping it invested in small-cap value. That way, at least under current tax law, it will never be taxed. Do this every year until all the money is within a Roth account.

Assuming that Brendon leaves this money alone and that it continues to compound at 12%, when he is 65 years old, your one-time $3,000 investment in small-cap value will be worth about $4.75 million.

That is still far short of $50 million. Let’s follow the money and see how this scenario plays out.

Assume that at 65 Brendon starts withdrawing 5% of the balance of his small-cap value account every year. That first year, he takes out $237,281. (Compare that figure to your $3,000 investment.) Because the money continues to compound at 12%, his balance grows, and so do his yearly withdrawals.

When he’s 70, he’ll take out $323,572, based on his account value of $6.47 million. At 80, the account is worth slightly more than $12 million, and he takes out $601,710 — theoretically without any tax liability.

If we assume Brendon keeps this up until his death at 95 (his final annual withdrawal being $1.5 million), his account will be worth about $30.5 million. Starting at age 65, he will have taken out a total of $21.6 million. That final value plus all the withdrawals come to more than $50 million from your initial $3,000. And, presumably, very little of it will have been taxed.

So let’s ask ourselves: What’s wrong with this picture?

First, future returns of 12% aren’t assured. Not by a long shot. (That’s why this investment is best made with money that won’t be essential for Brendon’s future welfare.)

Second, by the time Brendon is a young adult he will figure out that he has a lot of money, and he will have to resist the temptation to spend it.

Third, it’s extremely unlikely that today’s tax laws will remain unchanged for the next 95 years. Congress could very well find ways to tax accumulations of wealth inside Roth IRAs.

Fourth, Brendon might someday have to relinquish half the account in a divorce.

Fifth, the elephant in the room, so to speak, is inflation. A withdrawal of $237,281 sounds like a bucket of money at age 65. But I can almost guarantee you that a dollar in the year 2080 won’t be worth the same as it is in 2015.

Assuming future inflation of 3% inflation, in today’s dollars, Brendon’s account at age 65 would be worth $694,821, and his first withdrawal would be worth $34,741. (That seems much less spectacular than the previous numbers I cited, but in real purchasing power, that single withdrawal has more than 11 times the real value of your entire $3,000 initial investment.)

At the end of his life at age 95, Brendon’s annual retirement withdrawals would total about $1.83 million, and his account would be worth about $1.84 million.

There, in “real” dollars, is the payoff: $3,000 becomes $3.6 million.

Brendon doesn’t have to do much to achieve this result, except for probably paying some taxes along the way. Presumably he will have discretionary income to invest in his own retirement account. That plus (if he is lucky) Social Security and other savings may meet most of his retirement needs.

That means the small-cap value account may be available to him for “extras.” And it also provides a very generous pool of money ($1.84 million in today’s dollars) for him to leave to his heirs.

Starting with $3,000 when Brendon is born isn’t the only way to achieve results like this.

You could invest $365 a year for the first 21 years of Brendon’s life.
You could invest $365 a year until Brendon is 21 and rely on him to continue that until he’s 64.
You could make an initial investment of $3,600 when Brendon is 21 and then count on either you or Brendon to continue adding $3,600 every year until he’s 64.
Or you could wait until he’s 25, invest $5,500, then count on him to add that same amount every year until he’s 64.
In each of those scenarios, the total of withdrawals plus ending values come out about the same, ranging from $52 million to $59 million.

However you do it, this scenario illustrates how a very-long-term approach can create opportunities for future generations in a family. And, of course, it’s not necessary to start with $3,000. Even a $1,000 initial gift can yield very rewarding results over a long lifetime.

Think of this as Einstein on steroids.

This topic has many facets. For readers who want to dig into the details for more information, I’ve prepared a page of links to three files that contain year-by-year hypothetical data showing how the plan I have outlined could work.

In addition, I have recorded a podcast called How to turn $3,000 into $50 million. This presentation outlines all the steps that parents and grandparents should consider in setting up this amazing strategy.

Richard Buck contributed to this article.

[flatbutt]

If only it were that easy.

[masraum]

And just in case anyone is curious about the guy. He's a contributor in the "Retirement Mentors" section of Marketwatch. Assuming this stuff is true, these days, he's more about education about $$ than trying to make a bunch. I assume he's already done that.

Paul Merriman, Retired Financial Advisor

Paul Merriman is a nationally recognized authority on mutual funds, index investing, asset allocation and both buy-and-hold and active management strategies. Now retired from Merriman, the Seattle-based investment advisory firm he founded in 1983, he is dedicated to educating investors, young and old, through weekly articles at Marketwatch.com, and via free eBooks, podcasts, articles, recommendations for mutual funds, ETFs, 401(k) plans and more, at his website.

In 2013 he created The Merriman Financial Education Foundation, dedicated to providing comprehensive financial education to investors, with information and tools to make informed decisions in their own best interest and successfully implement their retirement savings program. A major project of the Foundation is funding the curriculum development and teaching of the 4-credit course, “Personal Investing” (for non-finance majors), at Paul’s alma mater, Western Washington University, which began Fall 2013.

In his retirement, Paul remains fervently committed to educating and empowering investors. In 2012, he wrote and published the “How To Invest” series, distilling his decades of expertise into concise investment books targeted to specific audiences – “First-Time Investor: Grow and Protect Your Money,” “101 Investment Decisions Guaranteed to Change Your Financial Future,” and “Get Smart or Get Screwed: How To Select The Best and Get The Most From Your Financial Advisor.”

Paul is also the author of four previous books on personal investing, including Financial Fitness Forever: 5 Steps To More Money, Less Risk and More Peace of Mind (McGraw Hill, Oct. 2011). The book was part of the “Financial Fitness Kit” offered on the TV show, “Financial Fitness After 50,” created exclusively to raise funds for local Public Broadcasting Service (PBS) stations.

Paul’s book, Live It Up Without Outliving Your Money! Creating The Perfect Retirement, published by John Wiley & Sons, was released in an updated edition June 2008.

Over the years Paul has led more than 1,000 investor workshops, hosted a weekly radio program and has been a featured guest on local, regional and national television shows. Paul has written many articles for FundAdvice.com, a service of Merriman LLC. This website was identified by Forbes as one of the best online resources for investors.

Paul’s weekly podcast, “Sound Investing,” was named by Money magazine as the best money podcast. Paul has been widely quoted in national publications and has spoken to many local chapters of the American Association of Individual Investors (AAII). Twice he has been a featured guest speaker at Harvard University’s investor psychology conference.

Paul began his career in the 1960s, working briefly as a broker for a major Wall Street firm. He concluded that Wall Street was burdened with too many conflicts of interest and decided to help small companies raise venture capital. In 1979, he became president and chairman of a public manufacturing company in the Pacific Northwest. He retired in 1982 to create his independent investment management firm.

Paul is the recipient of a distinguished alumni award from Western Washington University’s School of Economics and is a founding member of the board of directors of Global HELP, a Seattle-based non-profit organization that produces medical publications and distributes them free to doctors and other health care workers in developing nations.

[MikeSid]

The miracle of compound interest is like weightloss. It's pretty simple in theory, but incredibly difficult in actual practice.

[pwd72s]

Precisely why I'd posted here that the key to financial happiness is not in having "stuff". It's to stop paying interest and have others pay interest to you.

The more "stuff" you have, the more "stuff" you have to take care of. It can get to the point that your "stuff" ends up owning you.

[masraum]

Originally Posted by flatbutt

If only it were that easy.

What's the hard part?

[masraum]

Originally Posted by MikeSid

The miracle of compound interest is like weightloss. It's pretty simple in theory, but incredibly difficult in actual practice.

As long as you don't spend it...

[id10t]

Mom took a life insurance policy out on me when I was 18. It is associated with a savings account that pays a fixed-in-contract 6%. Currently 12k in the account, needs 5k in it to make the monthly payments automatically. Extra goes back into the savings account. Assuming I live to "just" 68 in addition to the 100k policy there will be another $49k ....

[flatbutt]

Originally Posted by masraum

What's the hard part?

12%...I have received as much as 13% on occasion but not consistently.

[bpu699]

Originally Posted by masraum

What's the hard part?

Reality doesn't match expectations...

I have been plowing 20k a year into the market since 1998. Market has returned nowhere near 10% a year. Two horrible down turns. Real estate crashed. Etc.

I don't care, as my time line is 20 more years. That said, if I had realized a 10% return annualized over the last 20 years, I would be retired. The market returned 3-4% I believe... That's a 3-4 fold shortfall in final returns...

Look at any graph of the Dow. From 1987 to 2000 it went if 500%!!! From 2000 to 2010 or so, it did squat. Went up and down. The last 5 years, went from 10,000 to 17,000.

If you were of age to invest in 1987 to 2000, and did, the numbers were in you favor. If you were a scmuck that entered the work force in 1999 or so... You got little compounding... If any.

There's a lot of cool calculators on the net. Some will show you what investing nets you, over whatever horizon and prior decades you back. My generation, now in my 40s, has gotten the crappiest returns over our investment horizon. The generations before, the boomers, could have recognized return 4x greater...



So goes life...

Nothing wrong investing in the market... Have realistic expectations.

[masraum]

Originally Posted by flatbutt

12%...I have received as much as 13% on occasion but not consistently.

What asset classes, and over what period? This guy admits that history does not predict the future, but based on the history that he's studied, small cap value asset classes (low cost indexs and mutual funds) will avg 12% over 40 years. They are more volatile, but also return a bit better than things like large cap or growth stocks.

[masraum]

Originally Posted by bpu699

Reality doesn't match expectations...

I have been plowing 20k a year into the market since 1998. Market has returned nowhere near 10% a year. Two horrible down turns. Real estate crashed. Etc.

I don't care, as my time line is 20 more years. That said, if I had realized a 10% return annualized over the last 20 years, I would be retired. The market returned 3-4% I believe... That's a 3-4 fold shortfall in final returns...

There's a lot of cool calculators on the net. Some will show you what investing nets you, over whatever horizon and prior decades you back. My generation, now in my 40s, has gotten the crappiest returns over our investment horizon. The generations before, the boomers, could have recognized return 4x greater...



So goes life...

Nothing wrong investing in the market... Have realistic expectations.

Kind of same as above, what asset classes, individual stocks or indexes and mutual funds. Actively managed funds or passive index funds? How much selling and buying have you done, and over what time are you looking at?

[bpu699]

Originally Posted by masraum

Kind of same as above, what asset classes, individual stocks or indexes and mutual funds. Actively managed funds or passive index funds? How much selling and buying have you done, and over what time are you looking at?

Like most folks, most in index funds and mutual funds. Which fund you pick effects return little, if you are diversified. The time window you invest in, plays the biggest role. Some decades are outstanding. Some lousy... Some of that is negated by dollar cost averaging over decades...

Bo

[Tervuren]

Over the past 14 years, return has been floating above or below 0% for me. I as a teen saved up a bit more than that $3k.

There is no guarantee, and things are looking really bleak as our currency devalues.

[masraum]

I think this guy, since he focuses on retirement, his period is often 40 years, Talking about people that are investing from the time that they are 25 until 65. That will make a difference. when you start going down to decades, the return may look much worse.

S&P 500


You were right though, S&P 500 from 1998 until yesterday would have netted you about 4.2% with the money growing from ~100,000 to ~200,000.

But if you Move that back, a little, even 3 years to 1995, then you'd be at the 8.2% for the period of Jan 1995 -- Jan 2016 (8.5% if you use yesterday's cost).

Go back to 1990 and you're at 10.1%.

Those numbers are NOT inflation adjusted. If you use inflation adjusted prices, you have to go back to 1986 to hit 8.3% If you bought 100 shares of the S&P500 in 2000 before the dot com bust, you'd be down (inflation adjusted, but you'd still have 202k vs 142k buy in.

I guess that's what you guys were talking about when you said "the hard part". You've got to invest early, and leave it there.

I think that's the point of the article above. Put 3,000 in when a baby is born, don't touch it, and let it sit until the baby is no longer a baby at 65 years, and based on history, you'll have a decent chunk of change.

[GWN7]

There is a guy out of the New York area named Madoff. He only takes on select clients but he gets fantastic returns. He can get you 12% (or more).

[Noah930]

Originally Posted by bpu699

If you were a scmuck that entered the work force in 1999 or so... You got little compounding... If any.

That's me!

My best investment to date has been my 930. Thank God I bought it instead of doing the "sensible thing" and investing that money in the market a decade ago.

I get what the OP is saying. I've thought about it even before my kids were born. But reality doesn't always match the predicted models. Which is why I haven't opened up Roth IRAs for them yet.

[bpu699]

Originally Posted by Noah930

That's me!

My best investment to date has been my 930. Thank God I bought it instead of doing the "sensible thing" and investing that money in the market a decade ago.

I get what the OP is saying. I've thought about it even before my kids were born. But reality doesn't always match the predicted models. Which is why I haven't opened up Roth IRAs for them yet.

So I am not the only schmuck .

I refuse to do a roth IRA. You pay the tax now, with the promise you wont pay taxes later... HA HA HA

Kinda like medicare, right? I pay now and get the money later? Riiiiggghhht.

The government will find some way to means test you, AMT tax you, etc. You will pay tax... If you believe that the government will allow you to accumulate a large nest egg, and spend it tax free... then you may also believe in pixie dust and unicorns...

[widgeon13]

12% consistently in the future is a freaking pipe dream especially with Hillary coming on board.

You'll be lucky if you can keep your IRA at all!

[GH85Carrera]

Originally Posted by pwd72s

Precisely why I'd posted here that the key to financial happiness is not in having "stuff". It's to stop paying interest and have others pay interest to you.

The more "stuff" you have, the more "stuff" you have to take care of. It can get to the point that your "stuff" ends up owning you.

Back when I bought my first house I got a great deal on the interest, ONLY 12.5% for 20 years. Now many years later, I am debt free and trying to earn interest the market rate in below 3% and 3% is hard to find.

I wish I had someone willing to pay me a mortgage rate at 12.5%