How do you build wealth with mutual funds?

A reader posted the following question a few days ago, regarding Dave Ramsey's "Pinnacle Point" where one achieves financial freedom from investments that deliver higher returns than expenses:

 

"I'm enjoying reading your financial stories and finding some valuable resources on your site--very inspiring to a musician in similar circumstances-thanks!  I have a question about something you mention above from Dave Ramsey: "That point gets achieved when the interest from your mutual funds exceeds your expenses."  I've never experienced nor do I understand the concept of "interest" on mutual funds; only swelling or shrinking with the rise and fall of the market and stock contained in the fund (as you go on to point out.)  Not having read Dave Ramsey's book from which you get this quote, could he possibly have meant "dividends" from stock as opposed to "interest" as something exceeding expenses in order to reference something tangible to offset expenses?"

 

Being in virtually every sense a money newbie (with a strong determination to learn, mind you), i re-phrased the question to my financial adviser as follows:

 

"Can you help me better understand how compounding works in the case of mutual funds/stocks which go up and down in value, as opposed to compounding a 'stable' savings account with a fixed interest rate?"

 

My financial adviser took a look at this and came back with the following response:

 

"Your reader's questions has to do with verbage rather then concept of compounding rates of return.  First let's cleanup the vernacular.  Interest is what is paid by a debtor (bank to customer, customer to bank).  It can be paid as the interest on the savings account.  It can be paid as the interest on a car loan.  It can be interest on a bond to a company.  Capital appreciation or capital depreciation is the value of something going up or down.  Your home was purchased for X, if you sold it for Y then the asset appreciated.  Stocks and mutual funds work the same.  Some stocks routinely pay dividends.  This is usually referred to as dividend interest.  Mutual funds can be made of of a variety of stocks, bonds, interest bearing devices and capital appreciating securities depending on what they are trying to achieve.  But I think your reader is missing the point of compounding interest.

"Here's how compounding works:  Supposed you made a 10% rate of return on $1,000 for 5 years.  You wouldn't say, "Well 10% for 5 years is 50%.  Therefore I have $1,000 times 150% = $1,500.  You would have to take $1,000  (110%) (110%) (110%) (110%) (110%) = $1,610.50.  This of course is more exaggerated the higher the rate of return and the longer the time period.  The formula for figuring out simple return is:

principle * [(period held) X (rate of return) ] + the principle. 

"In computing compounded return we take the [(1+ rate of return) to the power of period held] times the principle.  Compounding has exponential growth the other has straight line.

"Regardless whether it is interest or capital gains doesn't matter.  You (and Dave) are really talking about compounding rates of return (not compounding interest).

"On a further point...  You mention stable savings account versus ups and downs of mutual funds.  It is extremely vital for long term returns to try to smooth portfolio returns by managing risk.  Truly the difference in long term compounding.  One of the things I think is fundamentally wrong with some quotes that Dave and lots of people make is assuming a 10% average rate of return is the same as a 10% annualized compounded rate of return.  VERY VERY VERY VERY Different. 

"For example if you have a 50% loss, then earn 20% a year for 4 years, then my average annual return comes out to 6%.  But look at this comparison of returns:

Starting at $100,000:

example of 6% average returns straight 6% interest
Year end return Year end return
$50,000 (50% loss) $106,000 (6% interest)
$60,000  (20% gain) $112,360 (6% interest)
$72,000   (20% gain) $119,102 (6% interest)
$86,400 (20% gain) $126,248 (6% interest)
$103,680 (20% gain) $133,823 (6% interest)

"For fun repeat this process if you'd like.  But if you take it out 50 years... It gets ugly.  Smoothing volatility is extremely important.  I don't think Kyosaki or Dave Ramsey take that deep enough.  In Kyosaki's examples it will kill you.  In Dave's example, it just makes some of his calculations unrealistic.

From 1926-2000 (albeit a nice ending point)

Stocks annualized an 11.04% return.  If you put $1 in 1926, you got $2,582 in 2000, but had swings from -68% to 163% in any given year.

Short-Term investments (like T bills or cash) annualized at 3.8% which turned your $1 to $17, with swings from 0% to 15%.  Which is better?"

 

Did your head hurt from reading all of that?  Yes, mine did too - i guess the main point to come away with is the fact that there is no "magic cash cow".  As much as i love Dave Ramsey's methods for getting out of debt, it seems that his mutual-fund-only investment recommendations are too optimistic to expect a consistent 12% compounded rate of return.  (sigh...i remember when i was able to sock away tons of CD's at interest rates of 10-12% - that helped pay for my wedding and honeymoon!)

In musicians' terms, while it would be nice to be a superstar soloist and command $50,000 fees per concert, for those of us in the 'real world' we tend to earn a living through a variety of methods in the following order of descending stability:

  • teaching students (very stable)
  • playing concerts (not as stable)
  • selling CD's (pretty unstable)

The more i read up on finance, the more it looks like investing works pretty much the same way - some things work more steadily than others, and it's better to try to have a variety of investment vehicles than to stick everything into one basket.  Don't get me wrong, i still have every intention on maintaining a steady habit of monthly deposits into my kids' 529 plans and my own mutual funds, but i'll be looking at them with a slightly more jaded eye and (hopefully) more realistic expectations for their future performance.  Now to work on that collaborative pianist cloning patent...




[ 02 May, 2008 ] • [ Hugh ]

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