The Other 5%
David P. Kirch, PhD, CPA
To my wife, Chris
and my daughters,
Debbie, Suzie and Cindy
and their families
There are two aspects to money;
knowing how to make it, and
knowing how to spend it.
If you have one of these without the other,
you are doomed to a life of misery.
Uncle Phil
Kirch’s First Law
The financial worth of anything is equal to the present value of its future cash flows.
A Truth
Every time you substitute a comma for the period in the first law,
it will surely cost you dearly!!
1
Introduction
The original title of this work in a different era was “Save the Poets”. The purpose of the work was to allow true workers, including housewives, laborers and yes, even doctors, to live a life pursuing their passions without monetary worry. If they were able to save and invest 10% of their earnings each year, after several years of wisely investing their money they will be able to pursue their true passions without financial concerns. This was the basis of the most fun course I ever taught- Greed 101.
But now I have a more satisfying reason to prepare this work. You, my three daughters and your husbands and families are my primary audience. I am now doing the investing for you, but I will not be here forever. I have written this to introduce you to investing. I realize that Debbie and Cindy have seen a lot of this before, but it has been a while. And for Suzie, this is brand new stuff. So I am writing this assuming that you are starting out knowing or remembering nothing.
I am also writing this for other readers. I plan for it to be an appendix in my graduate level accounting course. If you are in this course, you will find a lot of what follows very simplistic. Wade through it. There is some real wisdom buried in some of this simplicity. Remember my primary audience, my daughters and their families are not at the same understanding of financial terms and systems as you are.
I am also writing this to select undergraduates. If you are one of these, you have been given this with a responsibility. The purpose and the responsibility is to give you a life of less financial stress. In return for this gift you must not use this financial power just for you. You must use some of it to make this world a better place for my grandchildren to grow up in. As long as one child is starving, or is sick without care, you have a responsibility.
Later in the paper we will talk about one of the greatest investors, David Tepper. Mr. Tepper gives huge portions of his money to make the world better. I expect the same from you. That is the cost of this “free” book.
A book that really sets you up for what is to follow is “The Richest Man in Babylon” by George S. Clason. It is the best book on money management available.
A final word. Many will read this and think it has some good points. To the extent that you follow what is here, you will be become rich. Period. If you think it has some good points and so apply some of the applications, you will become somewhat rich. Period. This works. Period.
Preliminary Considerations
What is Common Stock?
We will be discussing investing in the “common stock” of companies. We will do this either through a mutual fund (described later) or by directly buying the shares, or “common stock” in a company.
So what is common stock? Common stock represents ownership in a company. It is called “common” to differentiate it from other, more exotic forms of ownership such as “preferred stock”.
Say you have an idea and want to start a company. You need $12,000, and you have zilch. To get the company started, the $12,000 has to come from somewhere. The bank tells you to take a hike. So you follow the usual path for raising initial capital, you find some investors. To entice the investors, you offer them ownership in the new company.
As we said, you have no money, but the idea and the passion for success is yours. You give yourself 20% of the company and find investors sold on your idea who are willing to give you $12,000 for the other 80% ownership of the company.
Let’s say you price the shares at $15 each (this initial price is entirely up to you and your investors). Now you get 200 shares and the investors get 800 shares and the business starts. If someone new wants to own a piece of your company, they can only buy it from you or one of the original investors. They cannot buy shares from the company.
As the fortunes of the business rise and fall over the ensuing years, the price others are willing to pay to own a piece of the company rises and falls. So any time you are buying common stock through Fidelity, Schwab or one of the other brokerage houses, you are buying it from people who currently own stock, not from the company. This is a gross simplification, but hopefully explains the basics of common stock.
Why not hire someone to do it for me?
Now this seems to be getting complicated and you might wonder why I don’t just suggest you hire a financial advisor to take my place. Because 95% of financial investors fail to do better than random picks would do over a ten year period[1]. “How can that be?” you ask. “How could they survive?” “Don’t people know this?”
Money managers sell themselves on everything but results. They are always very personable and exude knowledge and confidence they most likely do not have! They will talk about the low variability of their stock selections, of how they are ranked with some peer group or another……. anything but how they did compared to the S&P 500. (This is the gold standard we will be using to gauge our investments- it will be explained soon). In other words, for most of them (95%), because of their ineptitude coupled with their fees, they cannot sell themselves on the only thing that really matters- how well they did compared with how you could have done yourself.
Notice what is missing from the following ad-
[2]
There is no mention as to how they did compared to against the market. Did they earn more than you would have, had you randomly selected your own stocks?
If you currently have a money manager or financial advisor, ask him or her how their advice has done compared to the S&P 500 over the last five years. If they tell you that you that that is not what they measure themselves against, or start talking about “risk adjusted”, “peer groups”, “alphas”, or any other such terms you do not understand- read this book, fire the advisor and take over your own future!
Getting Started
Notice that if 95% of money managers fail to beat the market, that means that 5% do beat the market[3]. The focus of this work is mainly on finding those 5%. When that part is finished, I will include a section on how to evaluate stocks you may have selected on your own. Another question to be addressed is raised by the above ad. Notice the last sentence,
What assurance do we have that measuring past performance of the managers of different investment opportunities have any predictive value about the future? Academic research seems to be mixed on this.
There is the school of thought which is known as the “efficient market hypothesis” which purports that any investment returns in the stock market are the result of chance- that the price of a stock is based on all the known and unknown factors about that stock and its future. Further, people who consistently beat the market, (see Warren Buffett below) are simply very lucky individuals[4].
Other research points toward exceptional individuals’ continued ability to outperform the general markets[5].
All this does not really matter. In the real world we know Warren Buffett exists and can no more ascribe his continued success over the last 50 years to chance than we can believe that we happen to be here by chance. And, if it is the bottom of the ninth, the bases are loaded, there are two out and you are losing by one run, do you want a batter at the plate who has hit .220 in the past or one who has hit .350? ‘Nuf said. Argument closed.
Investing is both an art and a science. I can, and do in this paper, teach you the science part. Warren Buffett says that the worth of any investment is worth the present value of all the future cash flows discounted at the appropriate rate. This is the science part.
You must start with that. And that is what you will learn in this paper. After that, the art part kicks in. This is selecting between alternatives generated by the science part. I tell students that this is the difference between Warren Buffett and myself. We both apply the science part in the same way. His application of the art part has been about $50 billion better than my application!!!
Rate of Return and Compounding
Before I start, I want to be certain you understand what is meant by “rate of return”. If you put $100 in the bank and it pays 2% interest annually, at the end of one year you would have $102. Your return is the 2% interest.
If you left it and the interest it earned in the bank for a second year, you would have $104.04 at the end of the second year. You would have earned 2% on the original $100 plus 2% on the $2 you earned in interest last year.
You still have a return of 2%, but it is now compounding- being applied to the original investment plus all the interest earned since you first made the investment. This is called compounding. In all our calculations in this paper we assume you leave the money in and thus the rate you are earning is calculated using compounding.
It is possible to work backwards in these calculations. From the returns we get on an investment, we can figure out what the rate of return we are earning is. For instance, in our above example, if we knew that we invested $100 and had $104.04 at the end of two years, we can use our calculators to find that we are earning 2% interest compounded annually. We will go into how to do this in a later section. Anytime we are talking about “return” or “rate of return” you can equate that with the interest we are earning[6].
If you skip ahead to the section on the S&P 500, you will find its annual Rate of Return has been 7.36% since 1950. This means that it has earned on average, 7.36% per year on every dollar invested since 1950.
Another thought before we go on………..
When you have excess money, you have numerous options with what to do with that money. You can, of course spend it. This is the most biologically satisfying alternative. Because our far back ancestors did not have refrigerators or ways to save food, immediate consummation made the most sense--- food rots! (See the book “Mean Genes”.) So we begin with a deck stacked against us. We are preprogramed to spend, to dissipate our assets as soon as we acquire them - before they spoil. And this predisposition is in our subconsciousmind, which tends to control us without our knowledge. So we begin the battle with our brain working against us.
Now let’s look at some Other Considerations.
First the options: Where can we put our excess money?Should we use it to pay off school and other debts? Put money down on a home? There are pros and cons here. There are tax deductibility issues and other considerations. How much should be allocated elsewhere is for you to decide judiciously. But at least 10% of your gross income must be invested in your future, in the concepts of this paper!
You may find that the interest you are paying on something is more than you can earn on your investments. But think about that. If you pay off high interest loans will you really save the extra money you save or will you spend it? Let’s avoid this dilemma- save 10%. Period!! Is this open ended? How much do you need to save? This brings us to Your Number?
Your Number
A popular exercise these days is to calculate how much you need to have to retire comfortably. So what is your number? Follow along. We start with four major assumptions.
First we assume that you would like to retire on $100,000 a year in today’s dollars.
This amount of money will go much further in your retirement because you will not have the everyday expenses you had when you were working. For instance, the amounts you spend on clothing, gas, lunch and other work related expenses will be much less and possibly some of the expenses will disappear altogether!
Second, we assume that the minimum you will earn on our investments over our lifetime is the 7.36% that the S&P 500 returns. (We will get to what the S&P 500 is shortly).
Third, we will assume a 2.2624% inflation rate. (This is the average inflation rate over the last 100 years. The current rate, as I write this, is 1.5%.)
Finally we will assume a 22% tax rate.
We will ignore any social security payments you may get as my generation might have eaten them all up by the time you are ready for them! And you can factor them into the worksheet presented in the Appendix.
Based on these assumptions, our formula for your magic retirement fund is
(retirement annual needs/(1-tax rate)X(expected return – rate of inflation)
For you this number calculates as
Annual Income needed
(1-Tax Rate) X (Return Expected – Inflation Rate)
For us
100,000
(1-.22)X(.0736 - .022624)
= 100,000
.78 X .050976
= 100,000
.03976128
= $2,515,009.58
So you will need about $2,515,000[7] in investments earning 7.36% per year to retire on $100,000 per year (in today’s dollars)[8]. At this amount and this rate of return, you can live and stay retired forever and never eat into your principal. The bad news is that that is a lot of money. The good news is we have a lot of time[9]. But we have work to do……………………
Turning off the straight road for a moment…..
Risk and Return
I would like to take time to describe another aspect of investing-
risk versus return.
Say you have the option of putting your money in a federally insured bank earning less than 1%. This is our starting point and carries no risk. From this ultra-safe extreme we move up the investment spectrum. At the other end of the spectrum, we have the ultra-risky, ultra high return investments.
Federally Browns
Insured Bank win super bowl
Say you are betting that the Browns win the Super Bowl. At this writing the Sports Books put the odds of this happening at 17,500 to 1. See on the above chart that for this proposition, the risk is huge and the reward is huge. Is the reward commensurate with the risk? That is the question!!!
The potential income from an investment must be considered along with its inherent risk. Basically, the more the potential income, the higher the risk.
This is not a uniformly equal relationship. This is akin to player poker. If we can find the reward outweighs the risk, we go with the investment.
A caveat- I use the following in the classroom. If I give you an opportunity
that has a 50% chance of winning a certain bet and, if you win, it pays off at 4-1,
how much it wouldyou invest in the game? Your normal answer would be
Back Up the Truck baby!!- all you can get! The math says thatfor a $100
investment with a 50% chance of winning, the payoff should be $200. But we
said it pays 4-1 so the actual payoff will be $400 if we win. We would get rich
quick taking investments like this. But what if the investment could only be
made if you invested all the money you have or will ever have? Now you must
reweigh the risk/reward in light of the commitment. Students invariably say
they would only take such a risk if the chance of success were 90% and the
payoff was at least 10-1. (Women students generally want even more, male
students tend to be more prone toward a lower risk/reward. We will discuss
gender investment differences later in this paper.)