|
What if we
increased your monthly contribution as your salary grows? Let’s
just increase your monthly contribution by 10% each year. In other
words, the first year, you add $100/month to your balance. The second
year you add $110/month. The third year you add $121/month and so on. In
this case, your income with 10% ROI would be $158 after 5 years, $544
after 10 years, $3,683 after 20 years, and $19,640/month after 30 years.
Compare the difference over 30 years: $4,793 with $100/month
contribution versus $19,640/month simply by increasing your monthly
contribution by 10% each year. That’s $57,516 per year versus $235,680
per year!
The following table compares the two cases
discussed above:
|
YEARS
|
MONTHLY
INCOME: Invest $100 per Month
|
MONTHLY
INCOME: Invest $100/month with 10% Annual Growth of Monthly
Investment
|
|
1
|
$25.47
|
$25.47
|
|
5
|
$108
|
$158
|
|
10
|
$291
|
$544
|
|
20
|
$1,283
|
$3,683
|
|
30
|
$4,793
|
$19,640
|
Obviously, this would be a pretty good model for
someone just starting their career. By the way, if you could get 15%
instead of 12.7% (very likely as your balance grows), your income would
be $9,748/month (or $116,980 per year). That’s more than four times
the average salary in this country today, and you aren’t doing any
work to get it. You could be walking on the beach, sipping Mai Tai’s
in the
Caribbean
, or in your basement playing video games … the money just keeps
coming in.
Now let’s look at those of you who already have
some money to invest. Let’s say you have $55,000. That’s close to
the average balance in a 401(k) retirement account for today’s typical
55-year old. Let’s say you invest your $55,000 using my techniques in
your 401(k), IRA, or taxable account; we’ll talk more about those
accounts later in the book. The results are tabulated for three
different average returns in the table below once again assuming you
only invest $100/month and you never change that amount:
|
Years
of Compounding
|
MONTHLY
INCOME
|
|
12.7%
ROI
|
15%
ROI
|
20%
ROI1
|
|
1
|
$674
|
$814
|
$1,139
|
|
5
|
$1,182
|
$1,559
|
$2,641
|
|
10
|
$2,312
|
$3,396
|
$7,289
|
|
15
|
$4,437
|
$7,268
|
$19,821
|
|
20
|
$8,433
|
$15,425
|
$53,607
|
|
30
|
$30,085
|
$68,838
|
$390,263
|
1 Admittedly,
it would be very difficult (probably impossible) to get 20% average
return on all your investment over the next 30 years, but 20% on some
investments IS possible. In fact, I’m holding several positions right
now, that are earning over 20% annual return on the amount I invested.
I think you’ll agree, any of the monthly incomes
in the table above after just 15 years is enough to change your
lifestyle. If you invest your $55,000 in a growth
investment, do you think you will have that level of income in 15 years?
Obviously, if you have a lot more money right now than $55,000 you can
invest, then you can generate much higher monthly incomes.
Growth
Investing versus Income Investing
We’ve briefly discussed the advantages and
disadvantages of growth investing and income investing. Let’s take a
few minutes and discuss exactly what growth and income investing really
means.
In general, a growth
investment is any security (e.g., a stock or mutual fund) purchased with
the intent that the price of the investment will increase. Even the
genre’ known as value
investments are actually growth investments by this definition. The
only difference is a value investment appears to be worth more than the current
market price of the investment in the eyes of the investor; in other
words, the current price is lower than it should be. Value investments
typically have good ratios such as a price-to-sales ratio less than 1.5
or a low price-to-book value ratio. A growth investment, however, is
typically priced fairly by the market, but the security is expected to
continue increasing in price either due to popularity with the multitude
of investors, demand for the products and/or services the underlying
company sells, or key ratios such as the relative price strength.
However, for a given stock, growth investing really
means the company tends to reinvest its earnings in the company’s
business in hopes of building the company’s market share for the
product or service, reducing expenses, etc. Since the earnings are
reinvested in the company itself, little or none of those earnings are
passed to the investor as cash (typically in the form of dividends
or return of capital). The
growth investor accepts the risk of receiving no earnings on his
investment directly in hopes of getting increasing price per share; this
approach also has tax-deferral advantages. Bonds can also be growth
investments when purchased while interest rates are high in hopes that
the price of the bond itself will rise when interest rates fall; thus,
the investor can sell the bond for more than he paid for it. However,
bonds also pay interest (since the bond is actually a loan to the
company, municipality, or government); thus, bonds are generally
considered to be income investments.
An income investment, on the other hand, generally
includes bonds, stocks that pay dividends, and mutual funds that invest
primarily to receive bond interest, mortgage interest, real estate
profits, or stock dividends. The primary feature that constitutes an income investment is the cash paid to the investor. A company that
pays its investors a dividend has agreed to share the success of the
company with the investors by paying a portion of the company’s
earnings to the investors (i.e., stockholders). A bond pays cash to the
bondholders in the form of interest. A Real Estate Investment Trust
(REIT) by law must pay at least 90% of its profits to the investors in
the form of dividends. Since a portion of the earnings of income stocks
is paid to the investors on a periodic basis, there is less money going
back into the business; thus, the share price tends to stay about the
same. Of course, the price of an income investment can fluctuate quite a
bit, but the income investor usually does not expect the price to
continue growing year after year as he would with a growth investment.
Normally, a bond pays interest monthly; income stocks and REIT’s pay
dividends quarterly; and income mutual funds pay dividends monthly;
however, there are many exceptions.
There are, of course, many hybrids between growth
and income investments. For example, lots of growth stocks pay a small
dividend of one to three percent. Some mutual funds are “growth &
income” funds that have a mix of growth stocks and dividend-paying
stocks, and some mutual funds are “balanced” funds that have a mix
of growth stocks, dividend-paying stocks, and bonds that pay interest.
And as I mentioned earlier, bonds can be held for growth as well while
they pay out interest. Generally, the longer the term of the bond (i.e.,
how long the underlying loan is designed to last), the more the price of
the bond will fluctuate as interest rates change.
Now, let’s consider some of the advantages and
disadvantages of growth investments versus income investments. The table
below summarizes the pros and cons of growth investing and income
investing:
|
GROWTH
INVESTING
|
|
Advantages
|
Disadvantages
|
|
Defers taxes to the date sold if held for
at least one year
|
Most people lose money when picking growth
stocks themselves
|
|
Lower tax rate for capital gains when sold
if held for at least one year
|
You have to invest lots of time performing
research to select and monitor your investments, or …
|
|
Value of your investment may grow faster
than income investments
|
You have to relinquish control of your
investment (and results) to a broker or mutual fund manager, and
his interests may conflict with your own.
|
|
|
Mutual funds (i.e., open-end investment
funds) are subject to the whims of the public. We’ll discuss
this more a little later.
|
|
|
Your ultimate success depends on when you
take the money out of growth investments.
|
|
|
Tend to be riskier than income investments
|
|
|
Short-term trading for growth results in
little tax savings and frequently limited profits.
|
|
|
Growth investing in a tax-deferred vehicle
such as traditional IRA’s, 401(k)’s, 403(b)’s, and
annuities are taxed at ordinary income tax rates when withdrawn
instead of the lower capital gains tax rates.
|
|
INCOME
INVESTING
|
|
Monthly or quarterly income provides cash
in hand that can be used to pay bills, have fun, or compound
your results.
|
Income investments (with the exception of
municipal bonds) are typically not tax-deferred.
|
|
Provides steady, predictable income and may
also have growth potential rivaling that of growth investments.
|
Bond, REIT, and some stock dividends are
taxed at ordinary income tax rates (typically your “marginal
tax rate”.)
|
|
Monthly or quarterly compounding allows you
to grow your income every month or quarter.
|
Most income investments provide low returns
on investment (i.e., 3 to 7%).
|
|
When you build a large income, you have
true financial freedom.
|
|
|
Taxes on income investing can be deferred
until retirement or forever in Roth IRA’s or Roth 401(k)’s
which allows long-term compounding without tax erosion.
|
|
|
You have true locked in profits every month
or quarter.
|
|
|
Locked in profits lowers risk compared to
growth investments.
|
|
|
Diversifies your sources of income.
|
|
|
Reduces your risk of loss of income (e.g.,
loss of your job).
|
|
|
Can replace the need for an emergency
reserve.
|
|
|
Allows low-risk use of advanced techniques
that would be considered high risk for growth investments.
|
|
|
Income investments tend to be less volatile
than growth investments.
|
|
|
