Rate of Return: Only Half the Formula

In this month's Financial Planning Magazine, Craig Israelsen noted a simple principle of investing that is often forgotten. Consider his example:

A 25-year-old earning $35,000 per year, who receives a 3% raise each year over the next 40 years, invests 10% of her income into a 401(k). This individual will have accumulated $275,000 by the time she retires assuming a 0% rate of return -- in other words, she will have contributed this amount over the 40 years. Thus, making contributions is the first engine of growth.

The second engine of growth is return. Assuming this individual achieved a 6% annual rate of return, she will have $880,000 when she retires. Clearly, returns are a critical element impacting the account value, but so are her contributions.

If this individual still achieves a 6% annual return, but only contributes 2% of her salary each year, after 40 years her balance would be only $176,000. To achieve an ending balance of $880,000 while only contributing 2% of her salary, the portfolio would need to generate an annualized return of 12.4%. Historical rate of returns illustrate that this type of return is not likely to be achieved over the long run. Thus, contributions to savings, not rate of return, is the primary factor necessary to help you reach your retirement goals.

Equally Weighted vs. Cap Weighted

Did you know there are two versions of the popular S&P 500 market index? The equally weighted version is similar to investing the same amount of money in each of the 500 stocks tracked. This varies from the more popular capitalization weighted version of the index, which is effected more by the movements of larger companies.

It has been widely reported that the S&P 500 averaged an annualized loss of 1% during the last decade (these statistics represent the performance of the cap-weighted version of the index). You might be surprised to learn that the equally weighted version of the index (ticker: S&P EWI) gained 6% annually over the same period, even though it invested in the exact same companies.

A main factor contributing to this disparity is the fact that the equally weighted version of the index is rebalanced quarterly, while the cap-weighted benchmark is not rebalanced. This is further evidence that rebalancing is a systematic strategy that's intent on buying low and selling high.

Sidenote: The "Best Stocks, Best Funds" proprietary strategy utilized by Net Worth Advisory Group operates similarly to the equally weighted version of the S&P 500. For instance, each of our stock portfolios (large cap growth, international value, etc.) consist of 50 stocks with an equal investment in each stock. Consequently, we do not place larger bets on some companies than on others. Further, the "Best Stocks, Best Funds" strategy is rebalanced annually, normally near the beginning of each calendar year.

Details of the New Tax Proposal

My associate, Curtis Smith, CFP, recently summed up Obama's proposed tax plan. Below is a summary of the items being discussed:

• The 10%, 15%, 25%, 28%, 33%, and 35% marginal tax rate structure would be preserved through 2012.
• A one-year, 2% cut in payroll taxes would make up for the expiration of the "Making Work Pay" tax credit. This 2% cut in payroll taxes would apply to employees only -- employers still need to pay the full cost. It is estimated that this will ultimately cost $120 billion in revenue.
• The estate tax would be set at 35% with a $5 million exemption per individual. Consequently, married couples who use their exemptions properly would not need to pay estate taxes if their estate is less than $10 million.
• Long-term jobless benefits would be extended through the end of 2011. This is estimated to cost $56 billion. NOTE: this is an extension of the program as a whole, not an extension of an individual's benefits. An unemployed individual will still only be able to collect benefits as long as before, but the program paying the benefits will be around for another 13 months.
• Businesses would be able to expense 100% of their investments in 2011 (retroactive to September 2010).
• The present R&D tax credit and other business-incentive credits would be extended through 2012.