Build Wealth on Firm Ground at Any Time

Physician's Money Digest, October15 2004, Volume 11, Issue 19

Money

The good

news:

The financial assumptions investorshold are likely based on shakyground, according to a recent articlein . It may seem that stocks havelogged an historical annualized return of10.4%. In reality, once you allow for inflation,fees, taxes, and poor market timing,stocks have returned far less than whathistory would have us believe. By uncovering the cracks in thefoundations that support our assumptions,we can develop a better strategy forsuccessfully building wealth.

Shrinking Returns

Thanks to the pioneering work ofRoger Ibbotson, PhD, professor offinance at Yale University, the standardbelief is that stocks have returned 10.4%before inflation—about 7% after inflation—from 1926 to the present. However,a more recent comparison of stockreturns in the United States with thoseof 15 other developed countries indicatesthat since 1900, the worldwidereturn on equities has been only 5% ayear after inflation.

Did investors actually see that 5%? It'sunlikely, considering the bite that brokeragecommissions have taken. Even theadvent of mutual funds didn't completelyeliminate the 1% to 2% fees strippedfrom investors' earnings each year.

The reason:

Those returns, according to the article,diminish further, due to investor tendenciesto buy high and sell low. According toa recent study, investors in the New Yorkand American stock exchanges saw theirreturns lag the markets by 1.3% annuallyfrom 1926 to 2002. Investors in theNasdaq did even worse, lagging by 5.3%from 1973 to 2002. Theybought and sold at the wrong time.

The problem with looking at historicalreturns and expecting history torepeat itself is that stock gains comefrom two sources: the investment return(ie, dividends plus earnings growth) andthe speculative return (ie, how investorsbid stocks up or down over time).

The stock market is dramatically differenttoday than it was years ago.Today, investment return runs about1.7% annually, while speculative growthhas averaged only 2% annually afterinflation. Added together, that return isa far cry from 7%.

Getting the Most

The following are steps you can take tobuild wealth in any market:

• Control costs. Slash brokerage costsby trading seldom. Reduce managementfees significantly by making low-costindex mutual funds the core of yourportfolio. Select and hold quality investmentsand you'll reduce your taxes toalmost zero.

• Be worldly. Since more than half ofthe world's stocks are traded outsideAmerica, it can be dangerous to have allyour money in the US stock market. Thearticle suggests at least 25% of your stockmoney should be kept in foreign equities.

• Seek value. Over the long haul,value stocks have performed better forinvestors than growth stocks. While thatmight continue, value stocks also cancushion any volatility that growth stocksmight encounter.

• Diversify. The three big credos ofdiversification are no longer stocks,bonds, and cash. Think, instead, humancapital (ie, your job and career), physicalcapital (ie, your home and other realpossessions), and financial capital (ie,stocks, bonds, and cash).