PRINCIPLES OF WEALTH ACCUMULATION

 

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Oconee Financial Planning Services LLC serves its clients by helping them meet their financial objectives. All such objectives have at their basis the accumulation and preservation of wealth which can then be expended or given away as clients see fit. The investment philosophy of the company can be stated in a series of fundamental principles which guide all recommendations.

Spend less than you earn.

This is crucial. In order to invest, you need some cash to use as your starting capital. Where will the cash come from? Well, if you have a rich uncle who will favor you with gifts from time to time, that's a possibility. Or maybe you'll inherit some money when someone who loves you dies and didn't forget about you in his or her will. Great! Then again, there's always the Publishers Clearing House or the state lottery which could provide a windfall for you. Who knows, you might even find a pot of gold at the end of a rainbow sometime.

We hope it happens to you. Good luck is a wonderful thing to have.

For most folks, however, it's better not to count on luck alone for the accumulation of wealth. Far better is it to put aside a certain amount from your earnings at frequent, regular intervals and invest it over a period of time. The amount does not have to be much, especially if you're young. Spending less than you earn is a sure way of building up capital and it's a great habit to get into. If you get a windfall as well, so much the better. Just don't count on it.

Use debt carefully.

We are a debtor nation in two ways:

  1. Our federal government has run up a public debt of trillions of dollars resulting from years of deficit spending.
  1. Individual Americans as private citizens viewed collectively are up to their ears in debt. They live in a world of plastic and charge consumer goods with abandon.

Sooner or later, this debt has to be paid off, governmental and consumer debt both. Governmental debt is the responsibility of all of us. What we don't pay off, our children and grandchildren will.

[As an aside: John Maynard Keynes, the noted British economist of the first half of the twentieth century, was criticized for his views on deficit governmental spending. He was told that in the long run, governmental debt would have to be repaid. His response was, "In the long run we'll all be dead." Easy for him to be so cavalier about the payment of debt! He never married and would have neither children nor grandchildren. It wasn't his heirs that would be stuck with the tab. It was other people's heirs who would have to reconcile the debt burden. This anecdote shows the wisdom of the thought that it's always easier to spend someone else's money than your own.]

Governments like businesses need to have debt from time to time to meet their cash flow needs for operations and for capital investments. In good economic times, our federal government should use excess revenues it collects to pay off part the national debt. In bad times it sometimes has to incur additional debt to help in an economic recovery. That's the way governments use fiscal and monetary policy to control the economy. And that's fine.

But consumer debt is another story.

Regarding consumer debt, we believe that there is good debt and there is bad debt. Good debt is debt used to make needed capital purchases such as a residence or a car. These are items that have great utilitarian value: after all, most people need to live somewhere and have got to be able to get around. And mortgage debt used to purchase a primary residence has the added advantage of allowing an itemized deduction of interest on your federal tax return. This has the effect of reducing the out-of-pocket cost of the mortgage loan.

Bad debt is made up of two kinds:

1) debt incurred to purchase non-essential items such as vacations, extensive wardrobes, etc. and /or

2) debt which carries a high interest rate. Among the worst kind of debt is credit card debt (e.g. Visa or MasterCard) which has rates sometimes as high as 22% annually. Some people with this kind of debt never pay it off but rather make minimum payments month after month and year after year with barely any reduction in principal.

This is not a good use of debt. This is not the way to accumulate wealth. It's the way to poverty or at minimum the way to deceased wealth.

Our philosophy is spend less than you earn and use debt only when it is to your advantage and NOT to the bank's advantage. Be your own banker. Credit cards are best used as a convenience for purchasing consumer goods or for emergency situations.

Time is your ally so start early.

Think about it: If you had invested one cent in the mid-first century, and that one cent was compounded at the modest rate of 4% annually, you'd be the richest person on earth. Yes, richer than Bill Gates and Warren Buffett combined. In fact, you'd have approximately $1.165946 to the 32nd power. That's 1,165,946 trillion trillion dollars (give or take a few trillion due to rounding errors) and that's probably more than all the money in the world.

How could this happen? By year 100, the $0.01 would have grown to $0.51. By year 300, its value would be $1,288.25. By year 700 it would have grown to $8,381,804,155. Now we're talking about some real money! (Our calculator had to go into scientific notation at year 800 with a balance of $4.233 to the 11th power.)

This is the magic of compounding. But compounding needs time to do its work as seen in the prior example. Here are some examples more in keeping with a reasonable life expectancy. All examples assume payments made at the beginning of each month and an 8% return taxed at 28%.

Payment
Amount
Years of
Compounding
Amount
Invested
Value at
End of Period
  $100     20     $24,000     $45,128  
    100     30       36,000       96,422  
    200     20       48,000       90,256  
    200     30       72,000     192,845  
    500     20     120,000     225,641  
    500     30     180,000     482,111  

As you can see from the $100 payment figures, an increase of 50% of the time for compounding (20 years increased to 30 years) results in an increase of 114% in value ($45,128 increased to $96,422). The same holds true for the $200 and $500 payments. An interesting comparison to make is between monthly payments of $200 for 20 years and $100 for 30 years. Although in the 20-year period more money was invested ($48,000 compared to $36,000), the value at the end on the period for the $100 payments was more ($96,422 compared to $90, 256). This is how time is your ally. You can often do better putting in less money earlier than more money later. In other words, it's not only a question of how much you put in, it's how early you put it in.

And here's a real life example of the effect of the early investing of a very small sum over a long period of time and letting it sit to compound.

Time: 1973 to 1983

Amount invested: $30 per month for nine months of each of ten years.

Total amount invested: $2,700

Investment vehicles: 50% fixed income fund, 50% common stock fund

Tax rate: Not applicable. (compounded tax free)

Value on June 1, 2000: $51,932

So you can see that even very small amounts can compound into sizable chunks of cash given enough years.

Dollar averaging works both ways.

Dollar averaging, or dollar cost averaging, is an effective way to build wealth through systematic, periodic investment of relatively small amount of money over a given period of time. Here's the way it works. Say you make a monthly investment of $100 in a mutual fund which you expect to redeem when you retire. The share price of the fund varies from month to month. In the first month the fund might be selling at $25 per share. Your $100 would buy 4 shares. The next month the share price might be $23 and you would have bought 4.3 shares. The following month the share price might be $23.50 and your $100 would have bought 4.26 shares. For the three months, you bought 12.56 shares for $300, and your average share price would be $23.89. By purchasing the same dollar amount each month, when the share price is higher you buy fewer shares and when the share price is lower you buy more shares.

"Market risk" is the risk taken when an investment is made that the share price will be higher when you make the actual purchase than it normally is and that if you were to sell the investment you might not get all your money back. Dollar cost averaging reduces market risk by averaging the cost of your shares over a period of time.

Some people worry that when the time comes to redeem their mutual fund shares the market might be low and they would not get a decent price for their shares. This is also market risk which can be reduced by dollar averaging the redemptions. By spreading out the sale of shares over an extended period of time (as was done with the purchase of these shares) market risk is reduced correspondingly.

Alternatively, if the value of your common stock mutual fund was going down, and you had some fixed income investments you might want to draw from them for a while until stock prices recover. But that gets into market timing and as such should be done carefully.

Don't try to time the investment markets.

"The market's too high. I can't make any money by investing now." This complaint has been heard time and time again over the decades. Whenever there has been a strong bull market, people who were not invested feel left out and don't want to get in because they think the market is too high. Of course, markets do indeed get overvalued. This happens on a regular basis. Then again, markets regularly get undervalued as well. Markets are driven by greed and fear. When greed is operative, stock prices get overvalued. When fear is operative, markets get undervalued.

Everyone dreams of buying stocks at the very bottom of the market and selling them at its very top. This is called market timing and there really are people who claim they can do this. Of course they can. Anyone can. But no one has yet to be found who can do it on a regular basis. Even a broken clock is right twice a day.

We believe that market timing is for chumps. It just can't be done consistently. Bernard Baruch, the fabled investor of the early part of the 20th century, made a large fortune investing in common stocks and said that he never bought a stock at its bottom or sold it at its top. So what are we lesser financial wizards to do? We recommend that investments be made over a period of months and years, over bull markets and bear markets, and let dollar cost averaging work for you. And if your time horizon is too short to allow for this, you shouldn't be investing in stocks in the first place.

Forget about market timing in order to buy stocks or bonds at their very lowest point. Remember: you don't have to be the first one at a party to have a good time.

When Uncle Sam gives you a gift, open it, rejoice, and be glad in it.

As a people, we Americans are taxed on our income at the federal level as well as sometimes at the state and local levels. These taxes are also applied to our investment income. Currently, interest, dividends, and short term capital gains are taxed as regular income subject to tax rates as high as 39.6% while long term capital gains are taxed at a maximum as high as 20%. However, Congress wants to encourage us to prepare financially for our retirement so it has given us some gifts in the form of letting us defer and sometimes even avoid entirely the taxes which would normally be paid on the earnings from our investments. These gifts include employer sponsored retirement plans such as traditional pension plans (defined benefit), 401(k) plans (defined contribution), Keogh and SEP-IRA plans for the self-employed, Individual Retirement Accounts of many types, and 403(b) plans for some employees working in the non-profit area.

Investment vehicles which allow tax-free compounding (i.e. tax payments deferred or avoided) are excellent opportunities for the enhanced accumulation of wealth. The differences between compounding in taxable accounts contrasted to compounding in non-taxable accounts are dramatic. For instance, assume you make payments of $100 at the beginning of every month to an account which yields an 8% return and you are in the 28% tax bracket. In a fully taxable account your balance in 20 years would be $45,128. If you were in the 31% bracket, your balance would be $43,866. However, in a non-taxable account, after 20 years your balance would be $59,295.

Keep your expenses down.

In some respects, accumulating wealth is like trying to have a profit in a business. The formula is a simple one:

For a business: Revenues less Expenses = Profits

For wealth accumulation: Investment income less expenses = Additional wealth

By applying this formula you can increase your accumulated wealth by either increasing income, reducing expenses, or both. Increasing income by taking moderate risk will be dealt with in another section, so for now let's concentrate on reducing expenses. Here are some ideas:

    1. If you invest in mutual funds, find appropriate funds which do not have a sales load (front or back), a marketing expense, or any other unnecessary charges. Use tax efficient, tax reduced, or tax avoided investment vehicles insofar as possible.
    2. Some investments are virtual commodities: index funds, money market funds, term life insurance, etc. Like other commodities which you buy in your everyday life (gasoline, telephone service, flour, sugar, personal computers) there are often barely noticeable differences between them. So buy the cheapest ones you can, that is, the ones with the lowest expenses. If you are paying more for your commodity than someone else, be sure that you are getting value for the premium you are paying.
    3. If you invest directly in stocks or bonds, doing your own research and making your own decisions as to what to buy or sell, don't use a full service broker. You would be paying for services not received. Use instead a discount broker offering on-line services. Your transaction costs will decrease dramatically.
    4. Any financial product that is presented to you through a salesperson is going to cost more than the same product purchased without the salesperson. Salespersons are paid for their services (as they should be) and the salary or commission they receive is an expense that will ultimately be paid by you. Ask yourself if you need to be sold this product or in contrast if can you purchase it independent of the salesperson.
    5. If you want to avoid all unnecessary investment expenses, it might be worthwhile to employ a financial planner to guide you through the financial planning process and help ensure that your investments are getting "more bang for the buck" by keeping expenses down. The upfront payment of a fee to a financial planner will probably save you many thousands of dollars over the long run.

Reconcile present needs with future needs.

This is a tough one. You want to have a secure financial future but you have a present life which requires that you spend the money you earn. What to do?

One approach is to deny yourself all the good things in life which require the expenditure of money. You could live in a dump, clothe yourself in rags, eat spaghetti every night, not spend a penny on anything you really want, and invest everything for a secure financial future. Unfortunately, an errant bolt of lightning might kill you just when you're ready to cash in your investment and begin to live well. This is not something to look forward to.

On the other hand, you might decide to live only for today. Spend everything you earn and then some. Live lavishly. Go on expensive vacations, dine out frequently, buy a new car every year, etc. You think, "Hey, I could be hit with a bolt of lightning tomorrow, so I need to enjoy life while I can." Fortunately (or unfortunately) you might live to be 100 and spend the last 40 years eating cat food, sponging off your children, not having a penny for anything except the very barest necessities. This too is not something to look forward to.

These two divergent viewpoints must be reconciled. We have known people at both extremes of this present-to-future continuum and we don't recommend either position. Since no one can reliably predict the future, a prudent approach is to take care of present needs but also plan for the future. "Pay yourself first" is the operational command. Every month when you are paying your present bills, pay your future bills by investing for the future. Even households with very low income can put a little money aside to invest for future use. For those who have difficulty in setting aside these funds for the future, the trick is to not get all the money in your hands. Have an automatic deduction taken from your paycheck and sent to the investment vehicle of your choice.

Stay the course but check your bearings.

To accumulate wealth, a person needs an objective and a plan to reach that objective. The plan should consider the person's current wealth and income, desired future wealth and income, life style, family responsibilities, anticipated longevity, risk tolerance, and a myriad of other relevant factors. The plan should be followed insofar as possible. If a certain type of investment is selected, then keep investing in it. For example, don't chase last year's yield in a new mutual fund by changing funds solely to capture that yield. One market sector or investment philosophy may do better than another in a given year only to have the situation change in the next year. This is the "stay the course" part.

However, times change, markets change and what might have been an appropriate investment at one time may not be meeting your needs at another time. This is the "check your bearings" part. Take for example utility stocks. Utility stocks were highly appropriate holdings 20-30 years ago. Many financial analysts would have considered them the bedrock of any stock portfolio because they provided steady dividend income with moderate growth and safety in the context of a controlled/regulated monopoly. Indeed, this kind of security was often referred to as the kind suitable for widows and orphans, such was their safety. But in today's financial environment they are inappropriate for many investors. The utility industry has become deregulated and has lost its safety of principal feature. Moreover, the once steadily increasing dividends have slowed their growth and are still subject to taxation albeit at a lower rate resulting from recent changes in the tax code.

As another example, investments in the "new economy" (e.g. technology, telecommunications, the Internet) should be a part of any portfolio expected to grow over the years. Many of the companies in the new economy didn't exist 20 years ago. Indeed, some of them have not been sold publicly until ten years ago. In the late 1990s there were many excesses in the trading of stocks in this industry and prices got out of hand leading to the collapse of the market. But the industry and its potential remain and will be an integral part of the economy.

So stay the course but do check your bearings periodically.

Moderate risk is good.

Risk and reward go hand in hand. The greater the risk, the greater the potential reward. The less the risk, the less the potential reward. How much risk a person should take is a key decision in an effort to accumulate wealth. Let's start with a basic fact:

All investments have some degree of risk.

At one end of the investment spectrum is a non-investment: stuffing the cash into the mattress. Aside from the obvious risk of loss from theft or fire, there is a significant inflation risk, that is, when the money is taken from the mattress to be spent its purchasing power may very well have diminished. Persons who invest (?) their assets in this way generally have a fear and/or distrust of markets. These are the paranoids.

At the other end of the investment spectrum is the investment in penny stocks or IPOs (initial public offerings of stock) of start-up corporations with no history, no earnings, meager revenues, and a very uncertain future. This type of investment is getting close to the line which separates investing from gambling. Some people who invest their assets in this manner have a lot of discretionary cash which they can afford to lose so they roll the dice and take their chances. These are the gamblers. Other people dream that they can buy the next Microsoft for a few pennies per share and become a millionaire in a few years. These are the dreamers.

Between the paranoids and the gamblers/dreamers are the investors who put their assets into established stocks, bonds, real estate, savings accounts, certificates of deposit, etc. We believe that money should be invested, not hidden away nor gambled. And this means that investors will have to accept some risk that their investment may or may not turn out the way they anticipated. The fact is that markets fluctuate. The fact is that money can be lost as well as gained as a result of investing it. Another fact is that no one can predict the future, but looking at the past can give us some guidance as to what the future might hold. We write guidance, not certainty.

Research on investment markets over a period of many decades shows that taken collectively investments in common stocks yield higher returns over time than bonds. The operational phrase here is "over time." In periods of recession such as the 1930s or the 1970s, common stocks went nowhere while bonds returned a steady income. On the other hand, in the expansionary environment of the 1960s and the 1990s, common stocks did much better than bonds.

How much risk should a person take in making investments for wealth accumulation? There are several factors to be considered while answering this question. A person's "time horizon " is of the utmost importance. Time horizon merely refers to the amount of time between when an initial investment is made and when the investment and/or its earnings are withdrawn. If a person is 35 years old and is investing for retirement at age 65, an investment in a diversified portfolio of common stocks may be the best investment. On the other hand, if this same person needs to have cash available in five years to pay for college tuition for one or more children, an investment in Treasury notes or a money market mutual fund would probably be better. [Note: in these two examples, we use the phrases "may be" and "probably would be" in recognition of the fact that there are many, many factors which must be considered in determining the appropriateness of a given investment for a given purpose. The scenarios presented here are for demonstration purposes only]

Another factor is risk tolerance. Although over time stocks have a higher total return than bonds, they fluctuate considerably more. Suppose you are invested heavily in stocks and the stock market takes a dive losing 25% of its value. You are devastated and depressed even though you know that over time the stock market will recover its losses and continue its climb as has historically been the case. Your emotions overwhelm your logic. You can't eat or sleep, you become depressed, irritable and unfriendly and make all those around you --- family, friends, coworkers --- feel the same way. If this describes your personality then you have a low risk tolerance and investing in common stocks is not for you. It could ruin your life as well as the lives of others.

A third factor is a combination of macroeconomic conditions and political considerations at the time an investment is made. Although we are living in an era an unprecedented economic growth, the business cycle has not been repealed. Sometimes stocks are a better investment than bonds and sometimes bonds are a better investment than stocks. And sometimes cash equivalents are the best investment. And what action the Federal Reserve Board takes has an overarching effect on everything.

Thus in determining how much risk is appropriate for a given investor, consideration must be given to time horizons, risk tolerance, and macroeconomic conditions as well as many other factors. But the basic fact remains: Risk and reward go hand in hand. We believe that moderate, controlled risk is the best way to approach investing for wealth accumulation.

Use insurance products appropriately.

To our way of thinking, when the word "insurance" is used in the context of financial planning it should often be followed by the word "protection." For most persons, the best use of insurance is to protect his or her assets: house, car, earnings potential, investments, etc. However for some persons the unique features of life insurance, especially the desirable taxation aspects of its earnings and its payout distributions make it a worthwhile purchase. Also, life insurance benefits can be structured to be tax free to the beneficiary. This can provide ready cash to the recipient which is paid outside of the probate estate to ensure adequate and needed liquidity. Moreover, irrevocable life insurance trusts can be excellent vehicles for the preservation and distribution of wealth as part of an estate plan.

However, cash value life insurance policies have limited value in a cost-effective financial plan. The life insurance aspect of the policy can be appropriate for the protection of the insured person's dependents, but the investment properties of such policies are not necessarily the best means for accumulating wealth. For most persons, it's best to keep protection separate from investments.

Develop discipline and focus.

We believe that the key to success in any of life's endeavors is discipline and focus, and so it is with regard to personal finance. Periodic investments in appropriate investment vehicles using the tax code to your advantage with insurance protection as needed are the means to wealth accumulation. This needs to be preceded by a focus on goals and objectives to set the course. It's that simple. And with a little luck, virtually anyone can have financial security.

 


 

Oconee Financial Planning Services LLC
22 Running Bear Ridge Road   ·   Blue Ridge, GA 30513
404-374-3048   ·   edwolpert@gmail.com

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