Behold the Power of Compound Interest!
by tgirschJuly 7th, 2008
So, back in 1998, my Dad gave me $1,000 to put into an IRA. Being young and irresponsible, but not that irresponsible, I put it into the IRA as suggested (divided evenly between a growth and income fund and a large cap value fund*), but did almost nothing with it since. I have since contributed a grand total of $75 additional to the fund. I have never withdrawn anything from the fund.
That makes my cost basis on that account $1,075. As of today, the balance in that account is $1,203.13, a profit of $128.13, and an ROI of 11.9%. Considering the age of the account (ten years), that makes my annual yield a whopping 1.1%! Whoooo! Notwithstanding the tax benefits of an IRA, I’d have been better off putting this into a freakin’ savings account, or better yet, a CD.
This is intriguing to me, because if I had been actively investing in this account, it would have made the cost basis much more difficult to calculate, and I’d have no idea just how poorly it was doing.
At any rate, it’s awfully tempting to shake the proverbial Etch-A-Sketch, roll this IRA into some other accounts (preferably ones that don’t suck), and hope for better returns in the future. Any suggestions?
* If you’re interested, the two funds are SCDGX and KDCSX.
UPDATE: I should note that this isn’t the sum total of my savings — far from it. It’s just an account that I opened ten years ago and largely forgot about. I understand the ups and downs of the market, but none of my other long-term investment accounts are doing quite as poorly as these. Although I do need to also start contributing to this IRA, since it’s a Roth, and the long-term tax benefits are potentially substantial.
Categories: Economics |
Both of your funds tanked last year or you would have done better.
when you are in a bull market, keep your funds in a low cost index fund. When it looks like a bear, move your cash to a CD based IRA.
Google 20/50 “weekly moving average”
when you are in a bull market . . . When it looks like a bear . . .
This is just market timing, the same as every other clever investment strategy. Of course you do better with a fixed rate of return in a declining stock market, and with an indexed mutual fund in a rising market. Identifying those markets eludes, in the medium-to-long run, every single fund manager who’s ever tried it. An average person reading the newspaper and investing in their spare time is going to get creamed.
As for your IRA, tgirsch, the standard advice applies: ride it out. Uncle is surely right (and would probably be right no matter what indexed funds you had chosen, over the last few years), but the corrollary is that you will make that loss back when the stock market regains its losses under a Democratic administration, and then carry onward from there.
Your experience underscores two vital lessons: First, stock market investments are a long-term strategy, where “long-term” has to be interpretable as “there will never be a point at which you have to have the money”. If that were your retirement fund and you had to retire right now, having lost a huge fraction of your investment in the last few years, you’d be screwed. But in your case, you can wait another 20 years or more for that account to grow - and it will. Then you can pick the time at which you want to “harvest” it: years before your chosen retirement date, you start shifting assets into safer, more conservative investments, and if anything goes really bad in that time you either wait it out if you think you can wait up to 5-10 years for the stock market to recover before you finally retire, or immediately shift everything into a fixed-interest account and lock in your retirement budget at that time. Stock growth is a safe investment if you have enough future ahead of you to recover from any conceivable dowturn and you’re not planning to take money out of the account; the account will go up and down, but you don’t care because you’re just going to let it go until the time is right, then pick an “up” point to harvest the account. As you get closer to a date at which you have to have the money, you have to move into less-volatile strategies.
Second, and more important, is the utter insanity - the truly evil, cynical, and stonehearted moral emptiness - of shifting Social Security to individually-managed stock market accounts, or, worse, investing the Social Security trust fund in the market. Most people don’t know anything about investing and will get taken by the army of scam artists that will spring up to give “advice” about managing the accounts (look into Medicare Part B insurance scams or any of the huge array of scams that prey on the elderly). In addition, the stock market is a horrible place to have your retirement money when the time comes to retire. Imagine if this vicious stupidity had been enacted by Ronald Reagan or George Bush Sr., and everyone drawing Social Security today had their retirement money in the stock market. They’d be desperate! The market is only a reasonable investment long before you retire, when you have the luxury of picking the right time to move to safer investments for your fixed-income years. Most retirees don’t have that luxury. Putting the Social Security fund itself into the market is even more stupidly insane, because then you can’t move it to a safer investment - it’s a revolving fund (some people pay in, others take out, from the same fund at the same time), so there’s no “retirement date” to plan for. The fund is deliberately invested conservatively precisely to avoid the volatility of the stock market, but the Republicans keep saying they want to put it all in stocks to “reap the benefits of the market”. How’s that looking now, assholes? In fact, that plan is simply part of their scheme to destroy Social Security itself - by privatizing it where possible, and bankrupting it otherwise.
A further piece of unsolicited advice: because you’re young and have time to outlast downturns, an indexed tax-deferred fund really is a good way to go, and provides an easy way to create some financial discipline for yourself. Making more contributions to the fund really will benefit you (unless you are maxing out on a different fund you haven’t mentioned). There will be downturns; don’t let this one discourage you (and don’t take the money out of the fund - that would be “buying high, selling low”!).
As to how to do that: The IRA contribution limit is now $5,000 per year; you can reach this limit by putting $400 per month into the account. Now, that’s a lot, and not everyone can afford it. But that fact leads to another popular investment strategy: “dollar cost averaging”. This is a disciplined strategy that doesn’t require any decisionmaking or guessing at market swings along the way, and which can actually make market lows work for you by using them as opportunities to “buy low”. What you do is invest exactly the same amount of money in your fund every month, up to what will take you to the annual max, or up to a limit that meets your budget - but it has to be the same every month. In this way, when the market goes down, your money will buy a larger number of shares of the fund, and when the market goes up, that month’s contribution buys fewer shares; in this way you are actually increasing the size of your fund more during downswings, then allowing it to grow during upswings. (And, of course, you are averaging the cost of your shares at some point between the low and high prices, while spending the same amount total on them each month - hence the name of the strategy.) This allows you some of the advantages of market timing without asking you to actually predict the market swings (it’s important to resist the temptation to increase your share contribution during low swings - that way lies madness); it also puts your investing on an affordable, disciplined basis, which makes it easier for you to keep at it. (In fact, technically speaking, the discipline aspect of the strategy is more important than the cost-averaging aspect, which mathematically is not an optimal investment strategy; in practical terms, however, having an approach that guides you into making regular and disciplined contributions can be good for people who would otherwise either ignore their accounts [as it seems you've been doing] or do something stupid.)
Here’s some good info on relevant matters:
http://en.wikipedia.org/wiki/Dollar_cost_averaging
http://en.wikipedia.org/wiki/Value_averaging
http://altruistfa.com/dfavanguard.htm
[Profiles of the two best performing mutual fund families.]
http://www.altruistfa.com/behavioralinvestingpitfalls.htm
[Discussion of investing strategies and mistakes.]
http://johncbogle.com/wordpress/
[Thoughts from the founder of Vanguard, generally considered the best-respected mutual fund.]
http://www.amazon.com/gp/product/0684872617/
[Book recommended by a financial-analyst friend of mine.]
http://fundadvice.com/sound-investing
[Podcast on investing, also recommended by my friend.]
My advice: never, ever have an IRA account with such a small balance. The fixed fees will absolutely kill you.
If you start off small, fine, but only do so if your intention is to continually grow the account to, at an absolute minimum, 5 figures. If not, consolidate the money into another account.
You’re right that the fixed fees have been hurting me, although for much of the life of the account, there weren’t any.
The larger problem I have is that since this account is a Roth IRA and none of my other accounts are, there’s not really any easy way to consolidate. I have no idea whether you can convert a traditional IRA into a Roth, for example.
No, I’m 99% sure you can’t convert traditional to Roth. Back when Roth started, there was a grace period where you could do the conversion, but that has long since expired.
I remember because I had to decide if I should do it. I didn’t. My reasoning: I’m a boomer, and I figured that once the boomers start to really tap their retirement accounts, the tax laws will be changed and the rates will be reduced or effectively zeroed out, thus making the conversion a mistake.
One more thing, since you invested in the equity market, it’s not really accurate to consider this an illustration of compound interest.
One more thing, since you invested in the equity market, it’s not really accurate to consider this an illustration of compound interest.
Yeah, I know. I realized it after I clicked “post,” and decided I was too lazy to change it. Actual compound interest, even at a low rate, would have outperformed this account.
All of this brings up a good question, however: When is it a good time / idea to sell a fund in favor of another one?
I agree with KTK that attempts to “time the market” are futile, but at the same time, there has to be some point at which you decide “fund X is bad, and I need to get out.” I understand why trying to micromanage a long-term investment account is bad, but there’s got to be something more than “dump it in, and hope for the best.”
For mutual funds, one thing you can do is keep an eye on the fund manager. Fund performance is obviously tied to asset allocation and market performance. The asset allocation will remain pretty much fixed and you can’t meaningfully figure out market performance in advance. But you can keep track of the fund manager, and if the manager is changed, you can expect he fund’s performance to change (relative to other funds in same category). The larger the fund is (ie the closer it, by default, emulates market segment performance), the less likely a manager change will significantly impact performance. And the more locked down a fund’s program is (the extreme case being an index fund), the less latitude a manager has impact (either positively or negatively) performance. But in smaller funds with more flexibility in strategy, the manager can be very important.
Oddly enough, while it is market timing, it’s just about the laziest and easiest market timing that you can do.
I had my IRA in an CD-like interest account. I was reading up on investment strategies and I found out that index funds beat most of the managed funds without the cost. While dithering on what to do, 9/11 happened. Two or 3 days later, the market opened, and fell. I felt good about the long term market in the USA so I let it all go into an E*Trade no fee S&P500 fund. No front end fees and no back end fees as long as I didn’t act like a day trader.
I must be like Warren Buffet to see that the market would go up in the long term after the slump that happened after 9/11.
Anyway, I got into cash on November 30, 2007. I also called up my old 401k (also in index funds), cashed that out, and had the funds put into my IRA.
Again, I had this amazing precognition idea that we were sliding into a recession. Wow, am I amazing or what?
Do you have the ability to contribute to a 401k? That’s just about the best investment because for the first three percent of my pretax salary that I put in, my big faceless corporate employer gave me a buck worth of free stock for every 2 bucks of index funds I bought. Instant 50% return!
I didn’t get in at the very bottom, and I didn’t sell at the very top, but I did very well. Of course if I had ignored all that and just bought gold, I could have easily tripled my money by now.
I seriously considered moving my money to bonds in October of last year. If only I had done so!
And I’m with KTK, over the long haul, when you try to time the market like that, you’re ultimately going to guess wrong. The big exception is in a case like 9/11, a major catastrophe with a big negative impact that you expect to recover from. Of course, if you’d gotten out a couple of days BEFORE 9/11, you’d have made a serious killing.
Yes, I contribute to a 401(k) (extensively, actually), and that account is doing quite well. Although my return is a lot less than 50%, because they only match 50 cents on the dollar for the first 3% (they match less for the next couple of percentage points, and then no match at all beyond that). I contribute a lot more than 3%, so my effective rate of “instant” return is more like 36%, and will go down further when I increase my contribution. Still, my cost basis there is pretty good, and is so even if I count the company match as part of my cost basis (thus eliminating the “free money” from the rate of return).
IRAs vs. 401k
Put your first 3% (or whatever they will match) into the 401k with pre-tax money. Then fully fund the max amount in your pre-tax IRA before putting any more into your 401k, because funds in the 401k are not as flexible, usually, than your own self-directed IRA.
On the time the market thingy, I’d have to say that in regards to 9/11, the market recovered fully to the 9/11 mini-dip by 12oct01 (about a month). Had I been in the market at the time, I would have held, which is KTK’s “stay the course” strategy anyway.
Likewise, well before Bear Sterns went from Enron-esque “everything just fine, just look at the rosy disclosure sheets” to belly-up in only three days, there were plenty of warnings, (#1)A stagnant housing market where before people were refinancing their ever-increasing home - taking cash out - to finance a lifestyle they could not afford. (#2) Funny business over at Fanny and Freddy. (#3) A very volatile stock market, Wild swings from day to day (#4) Yields on Treasury notes going down because more people were buying them.
What finally put me on edge was the ever increasing pitch of all the talking heads on the mainstream media news repeating the mantra “ride it out”.
Again, I’m not day-trading here, I’m doing the “invest in index funds for the long haul” thingy, except I’m jumping into CDs when things look obviously bad. I don’t think I’ll miss out on much of the market’s double digit growth, and I doubt I’ll get “creamed” either.
Of course if I had ignored all that and just bought gold, I could have easily tripled my money by now.
Slick Rick = the original Jim Kramer!