Triple Your Investment Returns in Four Easy Steps

    September 26, 2003

Whether you’re young and just starting out, you’re approaching mid-life and accumulating savings or you’re nearing retirement age, you can put a huge number of extra dollars in your pocket and in the pockets of your heirs if you just do a few things right.

Every year I speak to high school students in the Seattle area, and I’ve developed a little talk that always gets their attention. I call it “How to Get Rich.”

I tell the students that if they will give me 45 minutes, I’ll teach them more about investing than their parents know. I tell them that what they learn can literally make them millions of extra dollars during their lifetimes.

The talk starts with some fundamental choices they have to make, the most basic of which is saving some money instead of spending it. We talk about investing in stocks vs. bonds, in mutual funds vs. individual stocks and about investing in tax-deferred vehicles like IRAs vs. taxable accounts.

Then I tell them that once they have decided to invest in mutual funds, there are basically only four things they have to do right in order to be much better investors than most of their parents. (I don’t really mean to be too hard on these young people’s parents. A few of those parents probably already are doing what I recommend, though I bet the number is very small.)

Step 1: Worth $1.6 million

The first thing I tell them to do is choose no-load mutual funds instead of load funds. Unfortunately for investors, the majority of new money invested in mutual funds is going into load funds.

Investing in a load fund is like trying to fill a bucket that has two holes in it. Imagine the frustration of pumping water into a bucket only to have 4 or 5 percent of it immediately run out a hole in the bottom. That is like buying a load fund, a transaction in which you agree that part of your money won’t ever be invested but instead will go to the salesperson.

Then imagine the further frustration of discovering a tiny leak in the side of the bucket that allows a continual trickle of water to flow out the side. That is akin to paying the higher annual expenses of a load fund.

A young person who does just this one simple thing can earn an extra $1.6 million in a lifetime as I will demonstrate.

Step 2: Worth $ 4.3 million

The second thing I tell the students they should do is invest in low-cost index funds. Index funds have many advantages, but the biggest one for the present discussion is low expenses. Cutting expenses to the bare minimum, as you do with index funds, is the equivalent of almost totally plugging the hole in the side of a leaky bucket.

Average investors typically own large-cap stock funds, and the average fund of that type has annual expenses of 1.18 percent, according to Morningstar. But if you switch to the average no-load large-cap fund, you will cut those expenses to 0.84 percent. The Vanguard 500 Index Fund, the granddaddy of index funds and itself a large-cap blend fund, has expenses of only 0.18 percent a year. The difference is small in one year. But over an investor’s lifetime, it’s enormous. A young investor who takes the first two steps, buying no-load index funds, can earn an extra $4.3 million in a lifetime, as I will demonstrate.

Steps 3 and 4: Worth $15.2 million

The third thing I tell them to do is to have half their money in the stocks of small companies instead having it all in the stocks of large ones. Typically adults invest in large-cap stock funds because these seem the safest. Adults do the same thing when they invest in individual stocks, buying familiar names like Microsoft, General Electric and Coca Cola.

But if you have half your money in stocks of small companies, over long periods of time you can expect to receive an extra two percentage points of annual return. In a year, two extra percentage points doesn’t seem like much. But over a lifetime of investing, it makes more difference than most people would believe.

The fourth step is to invest half your money in value stocks. These are companies that are out of favor; their stocks are not in great demand and can be bought for bargain prices when compared to those of the popular growth companies. If you invest half of your money in funds that own these un-loved companies, over time you can expect to receive an extra two percentage points of annual return.

It might sound like I’m saying one-half of your portfolio should be in small-cap stocks and the other half in value stocks. But that’s not it. I’m advocating a four-way split, with 25 percent each in large-cap growth stocks, large-cap value stocks, small-cap growth stocks and small-cap value stocks. That way, you’ll have half your money in growth stocks and half in value stocks; and you’ll also have half in small-cap stocks and half in large-cap stocks. (To illustrate this, I like to draw a simple diagram on the blackboard, and sometimes I’ll ask the students to help me get the percentages right. It doesn’t take them long at all to come up with 25 percent in each of four style boxes.)

These last two steps have the most dramatic effect on how much money a young person can earn in an investing lifetime.

To recap, I tell the students that their parents most likely buy large-cap stock funds that charge a sales load. I tell them that if they change that pattern only by using no-load funds, they can earn an extra $1.6 million. If they go further and use no-load index funds, they can boost their extra lifetime earnings to $4.3 million.

Then I ask how much extra they think they’ll get if they go all the way and use no-load index funds to diversify into small-cap stocks and value stocks as I’ve just explained. Once in a while a bold student will suggest the answer could be $8 million or even $10 million. But when I tell them the result of doing all these things right is an extra $15 million, they are amazed. (At that point, I sometimes notice some students starting to write down what I’ve said!)

That’s right: The payoff can be $15 million just for doing four things:

1. Avoid paying loads or sales commissions.

2. Keep your expenses at rock bottom levels.

3. Have half the equity funds in your portfolio invested in small-cap stocks.

4. Have half the equity funds in your portfolio invested in value stocks.

International equity funds

Readers familiar with my investment recommendations may notice that I’ve said nothing about investing in international equities. Don’t assume this means I no longer advocate international investing. Indeed, I still believe U.S. investors will benefit by having half of the equity part of their portfolios in international funds.

I have left out that step in this discussion because I’m not convinced that adding international funds would add significantly to long-term returns. International funds certainly will add valuable diversification and will reduce risks. Including them may increase the investment returns I’m projecting in this article. But I don’t believe that additional step is necessary to illustrate the enormous advantage of doing a few things right.

Although the greatest benefit will go to young people, because of the long time they have until the end of their investing lives, more seasoned investors can benefit enormously, too.

I’ve done a series of calculations based on assumptions that I think are reasonable, conservative and realistic. One set of calculations starts at age 21. Another assumes an investor “sees the light” and takes these four simple steps at age 40. A third set of calculations begins with an investor at age 55.

Now let’s look at the numbers and the calculations so you can see for yourself.

I began with some assumptions about an investor, trying to strike a balance that represented the behavior of someone who takes investing seriously without assuming massive new investments every year.

Here’s the investor profile: Regardless of her choice of funds (purely for linguistic convenience, I’m using the female pronouns throughout this article), our hypothetical young investor begins at age 21 investing $2,000 into a Roth IRA on her 21st birthday. She invests that amount every year through her 29th birthday. Starting at age 30, through her 39th birthday, she adds $5,000 a year. On every birthday from 40 through 49, she adds $10,000. Finally, from her 50th through 60th birthdays (11 of them), she adds $15,000 a year. This reflects the reality that young investors have less they can put aside, and that people typically have more surplus funds to invest later in life.

These annual investments will be impossible for some investors, easy for others. But by and large they are feasible amounts for a wide range of people who make investing a priority in their lives. Roth IRA contributions are limited to $3,000 a year ($3,500 for those 50 and over). But 401(k) plans give enough extra room that many people can invest these amounts in tax-advantaged accounts.

I assumed this investor makes her last contribution on her 60th birthday and one year later, at age 61, retires and begins drawing out the money. I assumed a withdrawal rate of 6 percent a year. In other words, she takes out 6 percent of the portfolio on her 61st birthday, leaving the rest to grow. Every time she has a birthday, she takes out 6 percent of the portfolio, presumably a rising amount.

I also assume this investor lives to be 86 and dies on her 86th birthday. (I know that is rude, but we have to make assumptions about these things in order to calculate results.) Whatever is left at age 86 goes to her estate.

That set of assumptions allowed me to compare different investment strategies in what seems like a reasonable real-world setting. For each step that I’m recommending, I calculated the size of her retirement fund at age 61, her first-year withdrawal for retirement expenses, the total of all annual withdrawals on 25 birthdays, from 61 through 85, and the size of her estate at age 86.

That way I can calculate a “grand total” of all her retirement withdrawals plus the amount left for her estate. In other words, all the dollars that an investment plan would provide for her and her heirs.

For a benchmark to represent what a typical investor does, I assumed all money is invested in a large-cap mutual fund that charges a 5 percent load. I had to pick a number to represent future performance of such a fund, so I assumed 11 percent. This is not a prediction, though I think it’s within the ballpark of reasonable expectations. It’s based on the notion, supported by history, that a portfolio of large-cap stocks can earn 12 percent before expenses.

This benchmark lets me improve the portfolio in steps, first by using a no-load large-cap blend fund, then by using a no-load large-cap index fund and finally by diversifying into four asset classes using no-load index funds.

Paul Merriman is founder and president of Merriman Capital Management in Seattle and editor and publisher of He is the author of two books on investing and writes a weekly column on mutual funds for