Financial Guild

My post from yesterday raised some eyebrows and ruffled some feathers. I suppose I used a bit too much glamour when I used the word “smoked” in the title. I tend to do that sometimes when I want to draw attention to a post.

Some questions were raised about my methods:

Why did I choose a 10-year period? Well, I wanted to compare American Funds’ Investment Company of America with Vanguard’s S&P 500 Index Fund. My source for daily data is Yahoo! Quotes. Their data only went back to the mid-to-late 1990s. Since I was calculating the reinvestment of dividends on my own, I wanted to have daily data.

Did I “data mine?” No, I did not. I did not search for a mutual fund that would support my position (because I did not have a position). I would have posted the results REGARDLESS of the outcome. As I stated in my previous post, I chose American Funds’ ICA because I was familiar with them and knew that they had been around a very long time.

So…

Since I didn’t have daily data going further back than the mid-1990s, I decided to switch to annual data provided in the ICA’s Annual Report and data that I have for the S&P 500 Index*. Here is a year-by-year comparison (you can click on the graphic to see a bigger version):

Those figures do not include a sales load. They also do not include a management fee for the S&P. So, to get a little more accurate picture, I assumed a $1,000 investment in each and deducted the maximum up-front sales charge of 5.75% for ICA. Then, I calculated the returns for the last 5, 10, 20, 30, and 40 years. Here are the results:

Remember, these numbers DO NOT include any sort of management expense for the S&P Index, which favors the index. Another thing to note is that looking at the data, I’m sure there were rolling periods in which the index beat ICA.

This figures all go to hell if you look at dollar-cost averaging since each investment in ICA would take a haircut. It would be hard for ICA to overcome that obstacle. That’s why I would ONLY consider a load mutual fund if I was investing a lump sum.
*Although I refer to it as the S&P 500 Index, the index was composed of 90 stocks prior to 1957.

I learned about American Funds during my PaineWebber days. A few of the brokers (though not enough in my opinion) used American Funds for their clients’ portfolios. One of the funds I liked from American Funds was the Investment Company of America. Yes, it had a front-load. But, the annual management expenses were quite low compared to other funds. I also liked the team approach to investing.

After I left PaineWebber, I quit following American Funds until the other day when I came across some old fund literature I had kept (yeah, I’m a recovering pack rat). Their numbers looked pretty solid so I decided to look them up to see how ICA performed over the last 10 years. Turns out they did pretty well considering what we went through over the last ten years. I decided to compare ICA’s performance with Vanguard’s S&P 500 Index Fund.

I assumed the following:

• a $100,000 lump sum investment placed on December 31, 1999 and held through December 31, 2009.

• a 4.5% front load on the ICA shares.

• the funds were held in an IRA so taxes were not an issue.

• all dividends were reinvested.

Here is the chart of the comparison:

The value of the ICA (Class A) shares (after the 4.5% front load) was $122,257 at the end of 2009 while the value of the Vanguard S&P 500 Index Fund shares was $90,165. That’s a $32,000 difference. Had the ICA shares not had the front load, the end value would have been over $128,000.

Now, the numbers would have been totally different had you used a different share class. I’ll rerun the numbers using the C-Shares, which do not have an upfront load but carry a 1.46% management fee compared to .66% for the A-Shares. Unfortunately, it can’t be an exact comparison because the C-Shares haven’t been around as long. I’ll use the last five years as a comparison.

The numbers also would have looked much different under a dollar-cost-averaging scenario since every purchase of the ICA shares would have been subject to the sales load.

Also, it’s important to note that not all load mutual funds are created equal. American Funds has a great reputation of holding costs down. Not all mutual funds take the same approach that American Funds does. I just wish their funds didn’t levy sales loads.

I read this letter to the editor in today’s Wall Street Journal:

“In ‘George W. Bush’s 2010 Tax Miracle” (op-ed April 15), Donald L. Luskin suggests that many wealthy owners of IRAs and other tax-deferred retirement accounts will convert their accounts to Roth IRAs ‘in exchange for freedom from taxes forever after on principal, income and gains.’

“Should anyone be so naive to think that this administration won’t later change the rules and begin to tax all gains on Roth IRAs for those families making above $250,000 per year?”

That’s been one of my concerns too. Not so much that Obama would change the rules but that the rules would be changed at some point in the future. Things the government could do to jack things up:

• Force people to include Roth IRA withdrawals in their income in calculating the tax on Social Security benefits.

• Force people to take RMDs from their Roth IRAs.

• Tax withdrawals for people over certain income thresholds.

I know, I know. I sound like a conspiracy theorist. But, don’t think for a minute that the government won’t change the rules. They’ve done it in the past and they’ll do it again in the future. Anytime they see someone supposedly using the system to their advantage, they’ll figure out a way to close the “loophole.”

Thoughts?

Yesterday I received an email from a guy who needed help with figuring out his personal rate of return using Excel’s XIRR formula. He had just started contributing to his 401(k):

3/26/2010 – $188.50
4/8/2010 – $377.02
4/16/2010 – Balance of $593.54

The XIRR formula requires both negative and positive numbers in order for it to work. So, the best thing to do is to enter contributions as negative numbers since they are “outflows” to you. Like this:

Then, the ending balance would be a positive number. I explained this to the reader and this morning he sent me back an email telling me that he did it but got a return of 314%, which didn’t seem correct because his company was telling him the answer was 8.53%.

Both answers are correct. This is because the XIRR formula is annualized. To get the personal rate of return for the this time period, we have to adjust the annualized number. It’s easy enough to do. You just use this formula:

PRR (Personal Rate of Return) = [(1 + 3.148)^{# of days/365}] – 1

To get the number of days you simply subtract 3/26/2010 from 4/16/2010 to get 21 days.

PRR (Personal Rate of Return) = [4.148^21/365] – 1

PRR (Personal Rate of Return) = [4.148^.0575] – 1

PRR (Personal Rate of Return) = [1.08524] – 1

PRR (Personal Rate of Return) = .08524 or 8.52% (different due to rounding)

In other words, his personal rate of return over that 21-dayperiod was 8.53% but if you annualize the number, it’s 314%.

Anyway, I hope this was helpful. The XIRR formula can be confusing.

Consumer spending has always been an important part of our nation’s GDP. In fact, consumer spending currently makes up about 70% of the GDP. That’s a lot.

Has it always been that way? I wanted to find out so I did some research and found the GDP and Other Major NIPA Series, 1929–2009: II (PDF) on the Burreau of Economic Analysis’ website. The numbers are in that report but I still had to do some calculations to find out the relationship between the GDP and Consumer Spending. Once I ran the calculations, I created this graphic:

Although it’s hard to tell, consumer spending has grown to become a bigger slice of the GDP.

Here are the hard numbers if you’re interested:

From 1929 through 2008…

• the GDP has an annual growth rate of 3.32% (through 2008)

• consumer spending has grown at 3.22%.

But…

From 1979 through 2008…

• the GDP has an annual growth rate of 2.79% (through 2008)

• consumer spending has grown at 3.06%.

So, in recent years, the gap has narrowed and consumer spending has become a more significant part of our GDP. This is due to the fact that manufacturing jobs are moving overseas and are being replaced by service jobs.

The troubling part to all this (at least to me) is that if consumers are up to their ears in debt and are working to pay down their debts, how can they keep up their spending? Not only that, but if consumers were borrowing in the past in order to fuel consumption, where are we headed for the future?

Thoughts?

I have heard of this little exercise before but I’m going to use the one found on pages 55-57 in Bill Schulteis’ book, The New Coffeehouse Investor.

Imagine you’re a contestant. There are ten boxes. Each box has an amount of money in it ($1,000 to $10,000), like this:

You are asked to choose a box. Which box would you choose?

The obvious answer is the box with $10,000! Duh!

Now let’s change the game up a bit…

Now there are ten boxes. Each box contains the same amount of money as before except this time you only know the amount in one box and the rest of the boxes are covered up like this:

You can choose the box with $8,000 or you can take a change and choose another box. Now which box would you choose?

Most likely, you would choose the $8,000 because the chances of picking a box with an amount greater than $8,000 is pretty slim (2 out of 9 chance or 22%).

To put this game in perspective, Schulteis writes the following:

With the stock market average consistently outperforming 75 percent ot 85 percent of all managed mutual funds, it is a tribute to the massive marketing machine of Wall Street that so many investors spend so much time and effort trying to select top mutual funds instead of following the lead of state pension fund administrators who have a vested interest in choosing the $8,000 box instead of gambling.

It’s important to keep this silly little game in mind when dealing with Wall Street, because Wall Street loves to criticize the concept of indexing as a boring approach to investing in which you forego all opportunity to beat the stock market.

Notice he’s not saying that certain mutual funds can’t beat the index. Rather, he’s saying the chance of picking one of those funds is rather slim.

Thoughts?

I like looking at numbers. I like taking situations and looking at them differently. One of the areas I have been thinking about lately is social security. A lot of us just dismiss social security as something that we pay into over a career and then the government will pay us back when we retire. This little exercise is an excerise in “what if…” analysis.

Imagine had you began a 30-year career in 1980, making $25,900 (the maximum amount of income subject to social security withholding). Imagine over your career you were always subject to maximum withholding. How much would you have paid into social security over those 30 years? Well, the graphic below will show you:

The wages subject to social security withholding rose 4.84% per year (geometric average) while the maximum amount paid in rose 5.53% per year (due to the increase in the withholding percentage). Over a 30-year career, you would have paid in over $115,000 and your employer would have paid in another $115,000. Your total contributions would have been over $230,000.

Of course this only tells part of the story because had you not paid social security, the money could have been invested elsewhere. Over the last thirty years (through 2009), the total return for the S&P 500 Index has been over 11.24% per year (.89% per month). If we assume fees of .50% per year, that brings the average annual total return down to 10.69% per year (.85% per month)*. Based on that, the account could have been worth over $739,000 at the end of 2009 (including the employer match). At a 4% withdrawal rate, the account would kick off nearly $30,000 in income the first year ($2,500 per month). Keep in mind that this is only for one person. Had your spouse also worked, the “account” would be much larger. According to the Social Security website, the maximum benefit in 2010 is $2,346 per month (at age 66).

I understand that social security is just that…SOCIAL SECURITY. Meaning, it’s supposed to fund a minimum retirement for people and is not actual accounts for those who make annual contributions (though the social security statement you receive makes it seem like you do have an account). This program could have been so much better had they stuck with a bare bones plan that took care of the indigent instead of everyone.

*My numbers may not appear to match up properly. The difference is due to rounding and the compounding of fees.

I found an interesting article, Incentives Not to Work, which contained this quote by Larry Summers in a book he published on economics:

“The second way government assistance programs contribute to long-term unemployment is by providing an incentive, and the means, not to work. Each unemployed person has a ‘reservation wage’—the minimum wage he or she insists on getting before accepting a job. Unemployment insurance and other social assistance programs increase [the] reservation wage, causing an unemployed person to remain unemployed longer.”

It’s a clear cut case of how something done to help people has unintentional consequences. People are going to do what’s in their best interest. If they can earn more in unemployment benefits than they can from working, then they will stay on unemployment. As long as we keep extending unemployment benefits, unemployment will continue to be a problem. If we don’t extend benefits and the benefits run out, people will find jobs—even if they are lower-paying jobs.

This is why it’s not the government’s job to be compassionate (yeah, a term President Bush used).

It’s been such a long time…

The last time the Dow Jones Industrial Average closed above 11,000 was September 26, 2008. That was 563 days ago.

It took the Dow 164 days to lose 41.25% of its value to close at a low of 6,547.05 on March 9, 2009. From there, it took 399 days to rise 68.11% to get back to a 11,000. What a ride.

Investing’s not for the faint of heart.

I just read this article:

‘Earthshaking’ Ways to Fix U.S. Debt

According to the article (and common sense) there are three ways the U.S. can get its debt under control:

• Cut spending

• Raise taxes

• Some combination of both

The article then went on to explain what would have to be done if the debt were to be paid off strictly from increasing income taxes. One of the ideas is to raise all the brackets by roughly 1/3.

Let’s explore that idea.

Here’s a look at 2009’s brackets (married) and the amount of tax paid on a taxable income of $100,000:

Now, here is what the impact of raising tax rates on the brackets would have on the same taxable income of $100,000:

That’s an increase of roughly $500 per month in federal income tax. For a family with $50,000 in taxable income, the difference would be nearly $200 per month.

It’s also going to impact those at lower income levels because the rates on the lower brackets would increase along with all the other rates. HOWEVER, due to credits and such, the impact wouldn’t be as bad for them.

We have to decrease spending. How? What? I have no idea.

Oh, and for those who think we should just put the entire burden on the “rich,” I’d like you to read this editorial that was in the WSJ recently: The Rich Can’t Pay for ObamaCare. In other words, the rich (including the congressmen and women who voted for this bill) will simply find ways to avoid paying taxes.

UPDATE: I wanted to add that these numbers begin at taxable income which is your income minus deductions and personal exemptions. If any changes occur to these areas, your tax burden could be higher. Also, keep in mind that the brackets are usually adjusted on an annual basis for inflation.