So, if you didn’t know, a distinction can be drawn between being wealthy and being rich. I won’t go into it, primarily because Google is a great tool that you can use to expand your understanding of simple words. BUT what I will do is post this article by William Baldwin that I found on Forbes with guidelines on how you build wealth (if you haven’t Googled it yet, wealth > rich). Long story short, it’s all about what you can retire on. Anyway, enjoy the read and have a great first Friday of December. I know I will.
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.