Saturday, August 11, 2012

Blueprint for getting rich – part II

All the ingredients for getting rich have been presented on this blog over the last number of years. So you have made the plan below and are now looking at the details of implementing it.  You defined your vision for the future; you’re saving $10,000 per year. The savings for the first two years were used to buy an apartment or townhouse condo.  And now we’re ready for step 5.

1.       State ‘Your Belize’ (i.e. your vision of the future):
You want to retire 25 years from now at the age of 22 - J 
That means you want to have a net worth of at least $1.5 million 25 years from now so that you can live and work independently of an employer. (In plain English you want to be able to say to your employer “scr/// you!” without losing your meals and house - J - I am having so much fun).
To do so , you as a household, will have to save around $10,000 per year. We do that by living below our means. Saving will initially be difficult but over time with increased pay cheques it will get easier. Maybe you can at later age save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as ‘Financial Indepence’.
2.      To do so you, as a household, will have to save around $10,000 per year. You do that by living below your means. Saving will initially be difficult but over time with increased pay cheques that will get easier. Maybe, at a later age, you we will be able to save $15,000 per year and speed up reaching your ‘financial adulthood’ also known as retirement.
3.   First you save a down payment for your first home using your TFSA (Tax Free Savings Account)
4.       You buy your home
5.       You put your annual $10,000 savings from now on in ETFs which are tax protected in your TFSA
6.       You will work for an employer who provides you with an attractive company savings plan.
7.       That’s all folks. See you in 25 years.

In spite of having bought a house your savings are not suffering and with each year passing you see your pay cheque increase as well. So, saving $10,000 per year should be no problem.  In numerous previous blog posted we have looked at investing in individual stocks or in ETFs. Building up a diversified portfolio is not difficult with ETFs. But we learned from Bernstein’s Four Pillars of Investing that we should not expect to do more than maintaining our saving’s purchasing power for later years. This may be a bit disappointing and we are ambitious enough to push beyond the envelope to make a bit more if possible.
For that we have to look at Bernstein’s assumptions.  He assumes that the typical investor cannot handle a lot of risk – so to minimize volatility he first of all recommends to diversify between stocks and bonds. That is not a bad idea normally, because when stock markets fall, central banks tend to lower the interest rate and thus bond yields often follow. This results in increased bond prices.
Bond yields though have fallen over the last 30 years since inflation peaked in 1982 and we have experienced overall a bull market for bonds. The fall in inflation has also reduced the nominal interest rate (i.e. the interest rate plus inflation) and this was good for stocks too. So both asset classes have experienced extraordinary returns .During stock market crashes like the one in 1987, bonds increased dramatically in value resulting in reduced losses for the overall portfolio.  Historically though, bonds have underperformed stocks significantly during most periods and that is because bonds, especially short term bonds (with maturities up to 5 years) are less risky with the chance of losing principal being very low. On the other hand, the chance of losing your stock investment was and is significantly higher. Higher risk means higher returns and thus on average stocks outperform bonds.
Stock price swings are much more severe than those of bonds and it is not unheard of for a stock portfolio to lose over 50% of its value. However, typically time will restore the portfolio value and then some more. Thus, as long as an investor doesn’t panic, i.e. has a strong stomach, his portfolio should bring the anticipated long term returns. But ‘long term’ may represent a very long time – we’re talking decades. When you’re planning a retirement portfolio we have decades to work with, in our Blue Print we’re planning 25 years out and possibly even longer. Just focus on the long term returns and consider the volatility a nuissance that does not affect your long term return. So instead of Bernstein’s 60% stocks and 40% bonds lets have 80% stocks and 20% bonds.
Jim O’Shaughnessy’s research showed us that not all stocks are created equal. Yes the overall market return may be 13% or using Gordon’s modified formula 12.6% or Jeremy Siegel’s 7% plus inflation. However, you instead may elect to invest in value stocks that are typically lower priced than growth stocks or even lower than the average stock. That is the thought behind our Low P/E Moderate Dividend Portfolio. O’Shaughnessy’s research of value stocks suggests average annual returns of 18% but losses during a bear market may temporarily be as high as 55%. Rather than selling during those down turns one should buy more thus improving your portfolio’s performance even further (over the long term).
Finally, Bernstein assumes inflation (about which we cannot do a lot) and taxes. For protection from taxes we Canadians are blessed with the TFSA and to a lesser degree with RRSP.  Our earlier blogs compared both tax shelters and the message is simple. If your current tax rate is lower than your future rate then the TFSA beat the RRSP hands down. Especially if you are currently in a low income bracket you should use up your TFSA contribution first and then place the remainder of your savings including the tax refund inside a RRSP. When dealing with dividends and capital gains, a normal investment account may even do better than a RRSP. Fixed income is better inside the RRSP rather than in a normal account.  So first we fill up the TFSA.
If you’re just turning 18, you are worst off because your max TFSA contribution will be $5000 and the rest of your savings should go into a regular account unless you’re in a high income tax bracket. In this latter case the surplus should go into a RRSP. Every year that you’re over 18 or if you have made no TFSA contributions to date then your max TFSA contribution increases by $5000 up to a maximum of $20,000 in 2012. Basically, each year a person over 18 is allowed a maximum contribution of $5000 and this contribution increases every year by $5000 minus your contribution made in that year. The good news is that a withdrawal (once a year) from your TFSA will increase your total contribution limit. Gorden Pape has an excellent book on the detailed workings of a TFSA.
Suffices to say that after two years of saving for your down payment and its subsequent withdrawal, an individual typically has in the following year at least a $15,000 maximum contribution space and up to a maximum of $25,000. When dealing with a couple the contribution space could be double and range from 15,000 to $50,000. Bottom line is that after buying your first home, there is plenty of room to put your $10,000 annual savings in a TFSA and protect it from taxes.
Now, taking this into account, you could invest in our ‘Low P/E Moderate Dividend’ portfolio with 10 Canadian stocks or in a U.S. ETF that follows a similar philosophy. Alternatively, when you hear billionaires like Jim Rogers talk about commodities in the not too distant future you should love to invest in Canada’s stock market which is overweighed in commodities and for further diversification you also should select a U.S. ETF mirroring the S&P500 or Dow. ETF purists would prefer the S&P500.  Finally purchase a short term bond ETF for your portfolio’s bond portion; preferably a Canadian one (nobody knows what will happen to the most indebted nation in the world – i.e. the U.S. so avoid their debt).  Now you have a tax sheltered and diversified portfolio that should return you between 7 and 18% annually – let’s assume that Jeremy is right and assume an average ROI of 7% plus 3% inflation or 10%.
Then after 25 years of $10,000 annual contributions for a total of $250,000, your portfolio value should be: $985,500 with no taxes due and thus a net present value (corrected for 3% inflation) of:  $470,000. Now that is a lot better than just maintaining purchasing power. Adding up the value of our apartment to that of your portfolio in 25 years, by your retirement you’d have close to $1.4 million or $670,000 in today’s dollars. We are well on our way to meet our retirement goal.

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