Nine Formulas For Wealth Building
This story appears in the December
16, 2013 issue of Forbes.
If you want to retire in style,
you’d better know the numbers. We have some formulas that will provide them.
The objective here is to steer you
to wiser investments and give you some insights about what will happen to your
assets and liabilities over time. The formulas are not complicated. They all
fit on the back of an envelope. Some are adapted from experts. Some we
concocted.
With these rules of thumb, you can
answer questions like these: Do I have enough in my 401(k)? Will a mortgage
refi pay off? What will it cost to send my kids to college? When is a
closed-end fund a bargain?
1. What Can My Portfolio Earn?
R = 5*S + 2*B – E
Utterly unpredictable as markets are
from month to month, their returns over long periods (meaning: decades) are not
a great mystery.
In this equation, R states, in
percentage points, the expected real return– return, that is, above and beyond
inflation. S is the fraction of your portfolio invested in stocks, B the
fraction in bonds. E is the percentage you lose every year to expenses.
Example: You have the customary
60/40 mix of stocks and bonds, and the funds you are invested in eat up 0.5% a
year in fees. Then 5*0.6 + 2*0.4-0.5 = 3.3.
Now, 3.3% a year is a decent return,
but it may be a bit less than you were hoping for. It’s enough to turn the
dollar you put into a 401(k) at age 25 into $4.04 at age 68. That is, scrimping
today will enable you to buy four times as much stuff in retirement.
The formula doesn’t allow for taxes,
which will come out of your retirement money at some point– at the back end if
you have a conventional 401(k) or up front if you opt for a Roth account.
Is a 5% real return on stocks
realistic? They’ve done better over the past century, but they are very
expensive today. John Bogle, the Vanguard founder and wise man of investing, is
telling people to expect a 7% nominal return less maybe 2% for inflation, which
nets to 5% real.
Bonds doing 2%? That takes some
optimism, and a willingness to invest in riskier corporate debt. Treasury bonds
are safer, but the 20-year, inflation-protected variety yields only 1.3%.
Take four directives from the
formula:
—If you are young and can stand the
volatility, aim for a stock-heavy portfolio.
— Don’t have cash. It earns
nothing beyond inflation.
— If you see a projection about
your retirement or about what some financial product will do that assumes a
return like 8%, be wary. The fellow doing the projecting probably didn’t allow
for inflation or expenses.
