Teaching skiing years ago taught me the importance of fundamentals. For example, I had to explain to people that the bottom of the ski pole had to be in the snow somewhere behind the feet if you wanted to push yourself forward. This, of course, was before today's young people enjoying the winter wilderness have only to hop forward on their snowboards like the "March of the Penguins."
In a similar vein, last week's column about what young people can accomplish by making substantial contributions into a retirement plan generated email asking me how compounding of annual returns worked. Others asked how I could presuppose that annual returns would be as much as 10 percent.
Starting with the 10 percent assumption, the basis for this is apparent in the average returns of stock-invested mutual funds over the past 10 years. This period best proves the point because it includes the greatest single market crash in 70 years. It's true that during this turbulent period, the 500 largest companies demonstrated a 10-year average of only 7.13 percent, including their reinvested dividends. But wait, there's more. A typical small company fund earned 10 percent over the same period. Technology funds earned 14 percent per year, and some health sciences funds had earned 16 percent per year by the time the dust had settled.
Meanwhile, a fund invested in diversified emerging markets earned 11 percent, while an international fund in developed markets earned 9.18 percent. All this in a period during which the whole world looked like it was going to hell in a handbasket.
To achieve these results, investors in stocks need to consider spreading money out over a mix of different investment types. The reasons are obvious. After eyeballing the results of the fund types outlined above, one would conclude that the presumption of 10 percent returns on average had withstood the test of time. The underpinnings of the higher returns have to do with something called the "risk premium." It's an invisible hand of economic forces that tends to reward those who subject money to investment types that involve more volatility and risk. Small companies, for example, demonstrate more ups and downs than large established firms, but over time, investors who stay the course will be rewarded with what is typically about 2 percentage points annually above what large companies would have gained. If this condition didn't exist, there would be no incentive for anyone to consider companies that involved higher risk. It's built into the system.
Spreading investments over several types of investment types dilutes the risk brought to the table by any single investment type, and this allows a collection of more risk-oriented investments to benefit from the risk premium (the possible 2 percent more) while the entire collection of funds demonstrates something closer to a straight line of results (which means less risk). We're hoping for an average of 10 percent overall. Reviewing these numbers back through time shows that we can achieve it.
As for the compound earnings, that starts with simple math. If we have $1,000 earning 10 percent, we will have $1,100 by the end of the year. The next year, as our $1,100 earns 10 percent, we will have $1,210 by the end of year two. Year three: $1,210 at 10 percent will be $1,331 by year-end; year four: $1,464; year five: $1,610; year six: $1.771; year seven: $1.949. That's about double the money in seven years. In seven more years, this $2,000 will double again to $4,000 -- and so on. In real life, the money is actually earned on a daily basis throughout the year, so compounding actually starts from day one each year and leads to the doubling of assets every 7.2 years.
Within a mutual fund invested in stocks, the annual returns are reflected in rising values of the stocks owned by the fund plus dividends paid by the fund's investments. Those dividends are reinvested automatically to purchase more shares of the mutual fund. The beauty of having all this money in a retirement fund (401(k), 403(b), IRA, etc) is that all gains are tax-free until years later when you start taking the money out. It's like the Southwest Airlines baggage cart sign that says, "I Carry Free Bags."
Bottom Line: Understanding these investment fundamentals and applying them with some discipline is the ticket to freedom from financial worries -- and maybe even more sex appeal. How sweet is that?
Stephen J. Butler is CEO of Pension Dynamics. Contact him at email@example.com or 925-956-0505, ext. 228.