Wealth without Work

The world is filled with financial advice on how to get rich with a modest investment. The ones that aren't complete scams usually involve investing in the stock market. The purveyors of financial products tout the high yields that the stock market consistently offers.

For example, the respected Teachers Insurance and Annuity Association (TIAA) quotes a yield for it's general stock fund of 10.4% since it's inception in 1952. This is a typical number quoted for long-term investments. Is it really possible that the stock market can generate such large returns?

When the same organization comes to paying out these funds in an annuity they commonly use numbers in the 4% range for stocks and 3% for bonds. Apparently they don't really think such yields are sustainable. If stocks grow at 10% a year and the economy is growing in the range of 2-3% over a long period of time where is the extra money coming from?

I did my own calculation to see if the quoted numbers actually reflect the performance that a person investing for retirement could expect. For the calculation I assumed that $3000 per year was invested in a fund that owned the New York Stock Exchange average. Each year the value of this average was divided into the $3000 and that number of additional shares were added to the retirement account. No attempt was made to account for taxes (which would be deferred in an IRA) or the reinvestment of dividends.

At the end of a 30 year period the value of the fund was computed. Starting years used were from 1967 to 1973 and thus ending years were 1997 to 2003. Thus, the end point was before, during, and after the latest stock market bubble. The amount of money that the fund was worth was then used to calculate a present value from the starting date. That is, how much interest would be needed at a uniform rate if the $90,000 total contribution was to equal the final value.

The final value ranged from about $408,000 to $664,000 depending on the end year. The compound interest need to achieve this amount therefore ranged from 5.67% to 6.89%. Notice also that if you were unfortunate enough to withdraw your funds in 2003 you would have lost about a third of the value compared to six years before. That's equivalent to having 10 of your 30 years of savings thrown away. Pretty risky for a retirement fund.

So why the difference it quoted rates? Because the financial service numbers always assume you put the money in at the beginning of the period and just leave it there. So to do what they want, you would have invest all $90,000 when you open the IRA (assuming you could contribute so large an amount tax deferred and had that much cash available). If we include dividends in my calculation you can probably expect the yield to increase by less than 1% since most companies have down played dividends over the past decade or so.

As a comparison TIAA offers a real estate fund with a nominal yield of 7.75% since its inception in 1995. This fund hasn't been in existence long enough to do a 30 year calculation, but it has gone up in value every year, unlike the stock funds. So your risk of having a considerable part of you retirement worth wiped out is practically non-existent.

Wealthy families learned this lesson many years ago and maintain their capital from generation to generation by owning income producing property (and businesses). To see how successful they are read "Wealth and Democracy: A Political History of the American Rich" by Kevin Philips.

Conservative financial advisors recommend a "buy and hold" strategy in a broad-based fund. However, the law of averages tells you that you only have a 50% chance of equaling the S&P 500 average this way. After all it's an "average" that means half of the funds do worse and half do better. So you can reasonably expect to earn around 6% nominally. This becomes around 4% true value once long-term inflation is factored in and explains why the annuities only pay out about this amount.

Your best bet is to invest in tax deferred accounts to the maximum extent you can legally do and/or can afford. If at all possible diversify so that a good percentage is in investments not tied to the stock market. It's impossible for everyone to become wealthy from modest investments. Money doesn't grow on trees.

I have a proposal for a mutual fund which might perform better than average. You can read the details here.

Moral: There is no free lunch

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Copyright © 2004 Robert D Feinman
Feel free to use the ideas, but the words are mine.