Many of us probably wouldn't be surprised that the average American man lives about 78 years, and that the average American woman will live 83. (The weakness associated with the Y chromosome, and scientific evidence for the eventual "extinction" of men, c. 122000 CE, will appear in a later post.) But it surprised the hell out of me that this translates into 28,470 days for men, and 30,295 days for women. There's a finite finality about those numbers.
These numbers got me to thinking: am I really getting a good return on all this reading? I decided to run some numbers.
I found the following:
1. Reading on saving a fair fraction (~10-15%) of my income probably paid off. ($811,421)
2. Reading on tax-advantaged accounts (IRA) probably paid off. ($850,740)
3. Reading on index funds paid off. ($824,283)
4. Time spent researching/trading individual stocks will likely NOT pay off.
Detailed explanations follow.
A word of caution before we start:
All of the examples below assume about a 10 percent average annual compounded return, based on historical S&P 500 data. However, as Warren Buffet mentions in his 2006 letter to shareholders, there may be reason to suspect that investors should NOT expect that average return. This has implications for the value of actively managed funds, and equity investing in general.
Now, back to the four points.
1. Reading on saving a fair fraction (~10-15%) of my income probably paid off.
This should be a no-brainer. But as evidenced by a negative savings rate in this country, it shouldn't be taken for granted.
Take for instance the example of the "latte millionaire".
Let's say you drink a latte every morning right before work (or in the afternoon). Let's also assume you spend about $5 for each latte, that you drink one a day, five days a week, fifty weeks a year. That translates into $1250 a year. Let's say you kept up your latte habit until you retired 40 years from now.
But wait, there's more! Let's also say you used the compound annual growth rate (CAGR) of 10.4 percent, including inflation, which according to Warren Buffet in his 2006 letter to shareholders is the average rate of return in the stock market. I'm going to simplify this and estimate 10 percent. For this analysis, let's also ignore inflation (roughly 3.2 percent) because it's irrelevant for the purposes of this analysis. (Also, latte prices would also inflate, meaning it wouldn't be a huge factor.)
How much would that latte money be worth in, say, 40 years?
As it turns out, it would be worth $609,815.
Note that this isn't counting taxes - if you wanted, you could probably make a pre-tax contribution into a traditional IRA instead of a post-tax contribution to your local Starbucks. Then the figures go up to $717425 for a $1470.58 pre-tax annual contribution (corresponding to a 15% income tax bracket), $813,088 ($1,666.67 pre-tax annual contribution).
A picture says a thousand words.
The morals of this story are
(1) Think twice about quitting if your company has a communal espresso machine.
(2) Compounded savings do matter.
Potential savings after 40 years: $811,421
At $10/hr (my current salary), worth it if I spent < 81,142 hours on this (= 3381 days, or 9.2 years)
2. Reading on tax-advantaged accounts
Yes, I'd say this helped me. Automatically, I potentially increased my rate of return by 15-25% by avoiding federal taxes. Including state taxes, I've probably avoided an additional 6%. Assuming I didn't spend an ungodly amount of time getting it through my thick skull that I am not morally bound to pay taxes above and beyond my strict legal requirement, then this was worthwhile.
Again, a table to illustrate. I assume I've somehow squirreled away about $4,000 pre-tax in savings.
Additional Notes:
1. Traditional IRAs tend to win if you expect to be taxed at a lower rate after retirement. Roth IRAs win if you expect to be taxed at a comparable or higher rate after retirement.
2. The 2008 contribution limits for both traditional and Roth IRAs is $5,000, not $4000. The maximum contribution limits for both traditional and Roth IRAs are indexed to inflation, and rise in $500 increments. The limits are the same, meaning you can get additional compounded earnings if you can invest after-tax the maximum amount allowed in your Roth IRA.
Potential savings: $ 850,740 (more factoring in increasing contribution limits)
At $10/hr, worth it if I spent < 85,074 hours to learn this (= 3545 days, or 9.7 years)
Note: This post does not cover other interesting tax-advantaged accounts, like 529 plans (for college), health savings accounts (for medical expenses), and of course, your company's 401(k)/403(b), nor does it cover the other nine or so IRAs that exist.
3. Reading on index funds
This, too, has paid off. According to Motley Fool, the average actively managed fund tends to underperform the S&P 500 by about 2%. How much does this matter?
The reasons behind this are many, including management fees and tax inefficiency (buying and selling securities costs money, and also generates capital gains, which are taxed. Index funds tend to have much lower turnover - a lower fraction of portfolio being bought and sold over a given time period - and therefore generate less taxable capital gains).
Potential gain in 40 years: $824,283
At $10/hr (my current salary), a good deal if I spent < 82,428 hours (= 3435 days, or 9.4 years)
4. Investing
At about this time, you might be asking yourself, What if I don't like being a passive investor? What if I think I can pick stocks, and outperform the S&P 500? What about becoming an active investor?
Obviously, it depends on how good you I am at beating the market.
If you've read Malkiel's A Random Walk Down Wall Street, or more generally subscribe to the idea that the market is efficient -- that is, prices reflect all known information. Note that this isn't quite the same thing as saying that prices will randomly fluctuate around a fair value. Nor is it to say that news doesn't affect stock prices. In fact, given what I'm reading about behavioral economics (and in particular, behavioral finance), there are a lot of features that don't jibe completely with a strong form of the efficient market hypothesis.
But all of that is somewhat academic. Let's stick with a simple question.
Let's say I spend anywhere from 10 to 500 hours a year managing my portfolio (10 corresponds to about 1 hour a month, while 500 corresponds to about 10 hours a week.) How much would I have to beat the market by in order to make it worthwhile? Let's calculate:
Wow. This means that if you are a full-time trader with a $250k portfolio, you need to outperform the S&P 500 (or your index fund of choice) by about 8 percent in order to do better than a $10/hr job. Of course, if you can do that on an annual basis, you could probably make money doing it professionally, while managing even larger amounts of money.
Key Points:
1. The decision between active and passive investing depends on portfolio size. Therefore, if you don't have much, sock it away in an index fund, or an actively managed fund that you are convinced will outperform, even after fees and tax considerations.
2. As your portfolio grows, it might be worthwhile to check in once in a while (say, annually) to readjust your portfolio. This is especially more important as you age, since you will be less able to recover from a sharp decline in the years before you retire.
3. That said, frequent checking can actually be detrimental to your portfolio performance. An interesting study by Benartzi and Thaler explores reasons for the "equity premium puzzle" - that is, why, when the stock market consistently outperforms bonds, would institutional investors, pension fund managers, and endowment managers consistently choose a roughly equal balance of stocks and bonds. (The reason, they suggest, is that these managers, like you and me, are subject to annual reviews, which skews their timeframe and their risk tolerance.) Long-term investors - know yourself, and know BEFORE you invest whether you'll be tempted to pull out of the market when faced with a 20-30% short-term decline (NOT an academic point in 2008).
4. These calculations DO NOT include trading costs and capital gains taxes. Therefore, these figures are conservative - you would have to outperform by a larger percentage than listed in order to make it worth your while.
5. If you like investing for fun, do it, but do it with money you can afford to lose, and with time you can afford to spend.
6. If money is really important to you, and you aren't born rich (with a large portfolio at your disposal), you're best off working hard in a high-earning profession. Be a doctor, a corporate lawyer, or an effective businessperson. If it's less important, but you want to be comfortable in retirement, go do what you like, but start saving now.
A final thought:
There's a hell of a lot more to life than money. In a later post I will comment on the other properties of a person's life that may make him or her happy, powerful, or otherwise important. But money is powerful in that it is a fungible, widely accepted form of power and value. It is important to know how to manage it, and what our time and comfort costs us, at least in monetary terms.
If you've read this in an hour, and follow the above advice, you may have saved about $2.5 million over your lifetime. Please consider making a donation to yours truly for providing you with this information (all of which I got for free from the Internet).
I hope to post at some point about estate taxes, another potential source of financial and personal grief.
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