The chart below illustrates how different investments performed over the last 16 years. These plots show your monthly account balances and the monthly balances include both your principal and capital gain. Please note that anything below the Consumer Price Index (CPI) blue line means that you didn't keep pace with inflation and you lost purchasing power. And also note that if you had sold your investments that were held for more than 5 years, the federal capital gains tax rate is 8%. So even though owning a mutual fund performed the best, the total portfolio value of $41,242 would be reduced to $37,943 which means that you were slightly ahead of inflation. So ask yourself was the risk worth it.
In addition, what isn't on the chart is the rate of inflation of education. This article was inspired by every family's dream of sending their children to college. College is now viewed as a must when 25 years ago it wasn't. On a personal note my undergraduate costs per year were around $2,200 back in 1977-81 and my graduate studies averaged $4,500 per year in 1980-84. Today the same undergraduate college costs $20,000 per year and the graduate school costs $13,500. This translates into an average continuously compounded growth rate of 9.2% per year for the undergraduate college. The CPI only increased by 3.3% per year during the same period. So the undergraduate costs rose nearly 300% faster than the rate of inflation! As for the graduate college, its rate of growth is 5.8% and it rose nearly 200% faster than the rate of inflation. Clearly, the cost of education is out of of reach for the middle class wage earner. So if the average of these two growth rates is used, the amount of money needed for education represents an 7.5% annual increase over the last twenty years. Even worse are the government's data which shows education's rate of inflation at 8% (NCES 2003 data: http://nces.ed.gov/pubs2003/digest02/tables/dt344.asp). How does this measure up to the average family's potential investment options? Well, if you could earn 8% which is the average annual growth rate of education, you would have needed to invest $19,000 18 years ago to have $80,000 today. The short of it is that you couldn't. As the graphs show, there was no way for the American family to get ahead financially. However, let's assume that you were one of the smart families and that you were able to save for college. If you had planned for college, and you were counting on your investments to pay for college, then you would have been way short of your goal given the realities of the last 16 -18 years.
It's simple. You would need at least $80,000 for a four year program and the stock market has only produced $38,000 thus far (using the data illustrated later in this article). You're still $42,000 behind, and worse yet, you'll need to sell half of your investments just to pay for the first year. (Think ahead about the market's overall direction over the next few years as the baby boomers pay for their children's college bills.) For comparison, your $100 a month savings plan would need to earn 13.6% every year for 16 years to amass $80,000. Clearly, this didn't happen and it will not happen.
This financial castrophe is worsened by the fact that today's dollars have less purchasing power. In addition, the government and the banks are getting proportionally more of what you earn each year leaving you with less. So every dollar that you spend on education uses proportionally a larger chunk of the families budget than you realize. A century ago, a family made a decision to invest in their children or in a business. There wasn't enough money to go around and do both. If the family invested in one child, the hope was to have that child find a better paying job. The opportunity to do better; the opportunity to move up in the world; the opportunity to improve their standard of living, while the rest of the family maintains the status quo. However, if the family decided to invest into a business the hope was for all members of the family to prosper. Each decision was a risk, and we all benefit from our ancestors taking those risks.
But what about the risks to today's family? The same choices are before each and every one of us, however the current consciousness of Americans is to go to college. It is as though there were no choice. Remember the reason for going to college was to improve one's standard of living. Yes, academics and the pursuit of knowledge are presumably important ambitions, but Mom and Dad didn't "sweat" so that their son or daughter could pursue knowledge. Your ancestors didn't cross the great oceans just so that you can learn somthing. Otherwise they would have stayed where they were. Their aren't many of us who can afford to just send our children off to college just to learn something. There is a purpose behind going to college besides acquiring knowledge - it's to build a careeer. It has to be worth it to the family to invest all of their life's savings. There has to be a pay-off somewhere down the line. The parents need to be gratified and the children want to succeed.
The problem today is that the payoff doesn't exist anymore. Jobs are being lost daily and they're not being replaced with better paying jobs. High paying jobs are disappearing and the entreneurnial spirit that built this country is waning because of big comglomerates squashing "Mom & Pops" out of the business. So a family will spend $80,000 for college and their child will be better off how? What is the return for that investment? Again the pursuit of knowledge is great but it doesn't pay the bills. More importantly, how many families can afford to send their child off to college just because everybody else does. There has to be a payoff.
We're sold on the idea of education because it was our parent's dream, and look at us, it worked. We're better off. But what will the $80,000 buy your child? The status quo. This is an expensive investment just to stay even, or perhaps worse, there won't be a job for them. The alternative of course is to start a family business but mass marketing has beaten down the doors of opportunity. If your wondering if there are opportunities then just look at what immigrants are doing. Many are franchisees, "7-11", taxi drivers, gas station operators, etc. Others latched on to nail and hair salons. Also pizzerias, delicatessens, and other fast food establishments soak up a large number of families wanting to get ahead. Learning a trade seems to be passe, but when they earn $60/hour, revisiting this option is not only cheaper for the family but a safer bet provided the world is still going to fix things. Of course you and your family could always invent the next "thing", but this isn't likely. There's always sports and entertainment, but who do you know to get in?
Basically, white collar jobs will be lost en masse so where will the new college student fit in? More and more products are made overseas, so where will the college student fit in? China and India are producing top notch engineers that earn 1/5 what American engineers earn? Unless the government requires a license to do something, then there really isn't a compelling case for spending $80,000 just to maintain the status quo.
The problem is that there is a dream behind going to college. It's more of an emotional decision than a rational one. Fortunately, today parents are earning enough money that they still see this as the best use of the family's life savings. They have planned for it and they're comfortable with carrying the debt for this. But when harder times force more families to chose between their mortgage or college, the answer will be obvious. Currently, a recent survey shows that those Americans that are out of work will "flip burgers". This is in sharp contrast to the same survey conducted just a few years ago. The bottom line is that Americans are in hock and owe big. They need money badly and will do anything to pay the bills. The only question that remains is, are you willing to bet the family's savings and go into debt for an education that merely requires that you read a book.
The point here is that the inflation rate of edcuation is out of control and the education industry is suffering from excesses that need to be purged. However, if everybody continues to send their children to college regardless of how much is costs then the education industry is happy to oblige. It's supply and demand. Currently, colleges have the upper hand since parents want it and they offer it. Competition exists but it's not controlling prices. There are over 10,000 colleges and 15 Million attending college with 9 Million attending full time (latest data from NCES 2003 tables: http://nces.ed.gov/pubs2003/digest02/tables/dt172.asp). Despite the fact that more children are attending college as a proportion of the graduating High school seniors than twenty years ago, now at 43% from 32%, more students are attending. Twenty years ago only 12 Million attended college. So demand is strong despite inflated prices and there seems to be no limit to these price hikes. Parents will just have to pay and pay dearly they will.
The chart below illustrates how much money you made from each of the different investments over the last 16 years. The difference between this chart and the one above is that this chart only displays the monthly balances of the capital gains/losses. Your principal is substracted so you can see the effect of each of the investments. Notice that Gold lost money almost immediately and it is still losing money today (-$969). As mentioned in the other chart, any investment below the Consumer Price Index (CPI) line means that you are losing purchasing power and your money is losing value. Both EE bonds and passbook savings accounts fall into this category. It should be no surprise that current interest rates favor both the government and banks.
If your investments earn less than the rate of inflation then the government is essentially robbing you of your wealth and decreasing its debt by devaluing it. For instance, if the interest paid to you matches the rate of inflation, then nobody gets ahead. You as an investor keep your purchasing power and the government's debt stays the same. Now if the government pays you more than the rate of inflation, then you are getting wealthier and the government is getting poorer - they owe more, or their debt increases. But if the government pays you less than the rate of inflation then it is able to rob you of your wealth and at the same they decrease the value of their debt over time. Their debt decreases because the current interest is less so they owe less interest and over time the debt they already carry is devalued by the affects of inflaton. For example, $1 Trillion of debt today will in 30 years be paid off with dollars that hold less value. This diminishes the impact of debt and that's why law makers don't need to control their spending. They will inflate the economy and devalue the debt they owe. So how do the banks fit in to to all of this? Low interest rates also favor banks because it lowers the cost of doing business and they keep the differential. Just look at the difference between the EE savings bond gains versus the passbook savings account gains. The Bank pockets this differential because they're free to use your money while it sits in your account. They know that they can use most of the money for investments and high interest loans because the odds of everyone running to the bank to close their accounts is slim. So think of it this way, as you parked your money in a passbook savings account, the bank bought higher yielding bonds and captured the difference. They paid you $4,414 and they made $7,200 with your money (this is the difference between the bond and passbook data on the graph) . Now let's face it, you needed access to the money for bills and other purchases, because if you had the extra money, you would have purchased the EE savings bond yourself. The only disadvantage to buying bonds is that you have to leave it alone and not spend it and as Americans we can't do that. So the banks are getting wealthier because they get to invest our money while we're not using it and the government is making us poorer by robbing us of both purchasing power and by offering rates below the rate of inflation.
The charts above shows you the relative performance of each type of investment a small investor can make. There are several investments presented and each uses the same scenario. The question we asked was what would your account balances be if you would have invested $100 each month around the middle of the month. You would have invested a total $19,700 ($100 from Dec 1986 to Apr 2003 or 197 months). These investment choices were made on the basis of convenience and transaction costs. By and large most investors don't have large sums of money to invest and so must start with nothing. So $100 was chosen as the sum to save each month for the future such as a family would do to start saving for college or some other major life altering event. These investment choices are easy and give you access to your money if you need it for an emergency and the fact that you could purchase these investments for free makes it viable since the smaller investor doesn't have much money to begin with. What's interesting now is that your local bank can make all of these transactions while back in the 1990s banks weren't allowed to purchase mutual funds for you. This was considered brokerage business and was against the law which was set up to protect us from another 1929 style market crash. But congress did away with this law so that banks could once again move more money around in more ways.
As you can see, investing in EE savings bonds almost kept up with inflation but notice that you didn't have to worry about losing your money. As for stocks, they had a wild ride but in the end they are still the winner as the best place to have put your money over the last 16 years. As for our investment choice for stocks, we chose to use an indexed mutual fund that mirrors the SP500. In addition, we needed to select a fund that was around for 16 years and the oldest SP500 indexed mutual fund is the Vanguard's Group investor fund VFINX. Now there are 100 such funds but back in the 1980s this was the leader. The reason for selecting an SP500 indexed mutual fund was because the SP500 is widely used within the industry as the yardstick by which all performance is measured. Two, if we had selected one particular stock we would have incurred broker's fees and these would have been prohibitively expensive. Today brokerage fees for small orders are $10 but back in the 1980s brokers charged $50 to $100 regardless of the fact that we only have $100 to invest. So stocks weren't considered as viable since a smaller investor needs to invest their money and not spend it on fees. Three, by using a no-load mutual fund you could invest in a highly diversified portfolio (500 of the largest companies in America) at regular intervals without any fees or charges. Then for comparison we created two portfolios. One tracked only the fund's price appreciation and the other tracked the fund's total return. By total return we mean the sum of three investment streams. First, there is price appreciation. The captial gain from the underlying stocks rising in price. Second, there are the dividends that are paid to you that are reinvested and third, there are captial gains realized by the mutual fund that are paid to you as the fund sells stock. These disbursements are reinvested and the importance of reinvesting can not be understated. Because as the illustration shows, stocks without dividends would have earned $8,200 less. The power of compounding interest works tremendously well with reinvested dividends because after these dollars are converted into shares they add to the number of shares that you own and they continue to appreciate in value. For example, in our illustration the first $100 invested in the mutual fund bought 3.9 shares and at the end of the illustration you would have owned 504.3 shares. The fact that you gained 101 shares as the result of converting your dividends represents a full 20% of your investment. Plus if we look at the fact that the total dividend of $6,622 increased in value to $8,266. These dividends increased your net worth by 25%. So if you took the money and spent it would have lost $1,644 (the difference bewteen the dividends total value and its appreciated value).
The passbook savings rate balance represents putting $100 a month in a savings account at your local bank. The Gold plot is a bit different in that if you wanted to buy an ounce of Gold, you would have to wait several months until your balance reached a level that was greater than the cost of one ounce. So with the Gold plot the money was placed into a bank passbook savings account and then when there was enough money in the account, one ounce of Gold was purchased (we assumed no transaction costs, or premiums, despite the fact there are usually premiums much like when you convert different currencies. Banks give you 2% to 5% less than the going rate when converting currencies and they charge you a premium for handling the gold.). After 16 years of savings, you would have accumulated 57 ounces of Gold.
Another implication that was not demonstrated on this chart is the impact of taxes. All of these portfolio balances represent pre-tax dollars and assume that you didn't take any money out of the investment. These are buy and hold strategies.
Also on the chart is a table of growth rates. These represent the real rates of return on investing $100 a month for 16 years. So do you see 10% or 20% returns on this chart? NO! As a matter of fact you wouldn't have earned 5% (interest compounded continuously). So although bonds aren't as exciting as stocks, think about those bond investors still earning 14% risk free from the US government. That's right back in 1981-85 you could have bought bonds yielding between 12% and 14% for 30 years and these are still out there paying bond holders $140 per thousand invested every year. Now your lucky if you earn 5% per year.
The point is to show you that realistically earning 10% per year isn't normal. Historically, over the last 100 years you would have made an average of 5.7% per year. So, if you're investing and you make 20% then the odds say you should take your money and run. Even 10% gains are above average, but Wall Street sells the "home run", or the "grand slam". These 100% plus gains are the equivalent of betting at the track. So set your sights on realistic gains and compound these over a decade and then you'll see who's ahead.
This chart was created so that you could see real effects of investing small amounts of money over a long period of time. These plots show you quite clearly that over the long haul both stocks and bonds compete for money and perform well. But as you can also see, the gains weren't very "sexy": 2.83% for bonds and 4.52% for stocks. There weren't any "home runs" and the financial markets certainly weren't giving away free money. So despite the greatest bull market ever seen, the small investor didn't make a million dollars. Investing is taking an educated guess on value and exploiting it. But figuring out if your the first to recognize the bargain or the last is the key to your success. By knowing the odds, you'll be better prepared to set your goals and learn when to choose which investment is the right one for the right time.
These plots do not attempt to use market-timing techniques nor do they attempt to use any seasonal cycles. These plots reflect the realistic and modest goal of saving a small amount of money for the future and should be used to compare against more complicated strategies. Remember that you would have put aside $19,700 of your own money over these 197 months, and that the passbook savings account earned you an additional $4,414. The EE Savings Bonds would have earned you an additional $11,592 and investing in the stock market without any dividends would have earned you an additional $13,361 and $21,542 if you add in all dividends and other captial gains. Gold hasn't done anything for you. Your balance would be $18,730 which is $969 less than if you had left your money under your mattress. Here's another way of looking at it. If you took your principal of $19,700 and bought gold today, you would have 60 ounces instead of 57 and you would still have $4,414 in your bank account. So owning Gold was the worst idea despite the fact that inflation eroded our purchasing power by nearly 50% during the past 16 years. As evidence just look at the CPI data and a long term chart of the US Dollar index. Clearly gold hasn't been the inflation hedge that it once was and raises the question as to why Gold hasn't moved higher in price with the devaluation of the US dollar.
Lastly, the inflation adjusted prinicpal plot (the second chart, Cumulative Captial Gain) shows you how much your $19,700 is worth today. It's only worth $15,848. However this contrasts dramatically with the fact that if you had $20,000 in Dec 1986 it would only be worth $11,607 today. In our case you only lost $3,852 of purchasing power while in the latter case you lost $8,393. The reason your $19,700 investment held up much better is because the lump sum of $20,000 had the full effect of inflation working against every one of those dollars, while investing monthly, you only had $100 that was devalued since Dec 1986 and the other $100 investments suffered less from the effects of inflation since they were in essence newer dollars. Another way of understanding inflation is to flip the scenario around. If the $20,000 were invested in Dec 1986 you would need to earn $14,364 just to keep the same purchasing power. So $34,364 in Apr 2003 is the same as $20,000 in Dec 1986. But there's another complication - taxes. If you would have had a capital gain of $14,364 you would have had to pay income tax on that $14,364. So if we apply the current long term capital gains tax rates, 8% (for property held longer than 5 years) would be taken away by the Federal Government. If we include the loss of purchasing power due to federal income captial gains taxes, you would need $37,353 just to keep the same purchasing power as $20,000 had Dec 1986. Add in state income taxes and you're up to $40,000. So you needed to earn an extra $20,000 just to keep the same $20,000.
The point being made here is that if you keep your money in cash; you lose. Your money is slowly becoming worthless and unless you find an investment that can keep pace with inflation and the taxes owed on any captial gains you lose. Secondly, think about this. You would now have to earn 100% more than you did back in 1986 just to stay even. How many of you have had pay raises that have exceeded the inflation rate? This is why the percentage of two wage earner families rising so fast. Lastly, as our purchasing power diminishes the impact of taxes grows. If your salary hasn't kept pace with inflation then everything you purchase is taking a larger chunk out of your paycheck. But as the government inflates our economy it isn't reducing the burden of taxes fast enough. So as your salary increases below the rate of inflation, your tax bills are rising faster than the rate of inflation. This means that the government is taking a larger share of our paychecks, or in other words, your working more for the government and they're robbing you of your wealth.
Over the last decade, individuals have been paying more in taxes than ever. Despite highly touted tax cuts, most of us are paying more in taxes because there are more types of taxes than ever. Add to this the fact that our money is worth less and you see where I'm going with this. So even if you make more money you're still slipping behind. This is all the more reason to insure that your money is working for you.
The next time a financial planner or adviser shows a chart with fantastic future projections make sure they show you something that is realistic and that suits your needs. And of course, now you know how much you owe your children.