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You're Smarter Than You Think
By Stephen J. Butler |
 Archives |
In the past
few weeks, I have heard a number of 401(k) participants express
concern about the losses in their accounts. As the reality of
last year's wild market fluctuations finally sinks in, some 401(k)
participants have been understandably traumatized by the experience.
For some of us, any confidence we might have had in our ability
to manage money has been shaken to the core. In fact, most people
have done pretty well if they have been contributing for five
or ten years. What we need is a working knowledge of a sophisticated
measurement tool that will tell us what we want to hear. We need
to calculate something called our Internal Rate of Return.
A stream of money flowing into an investment program generates
a different rate of return than a single amount of money contributed
once. To take a simple example, if we had $10,000 in a mutual
fund that earned $1,000 in the first half of the year and lost
$1,000 from July 1st through December 31st, the return for the
year would be 0%. However, if we started with $10,000 and invested
a second $10,000 on June 30th, our loss on what became a $20,000
account would be $1,000. The second $10,000 wasn't in the fund
to enjoy the success of the first half of the year. Instead, it
was only around long enough to get saddled with the loss. It therefore
dragged our total account value down to $19,000... a 5% loss for
us with a mutual fund that showed zero change in value for the
year.
Timing can be everything. A single investment in a Total Stock
Market index at the beginning of 1993 would have accumulated to
2.8 times its 1993 value as of the end of 2001. This represents
a 14% per year average rate of return. However, a constant annual
investment in the same mutual fund for the same nine-year period
would have generated an internal rate of return (IRR) of only
7%.
Why the difference? The steady contributions over time meant that
the latest contributions only reached the account in time to get
slammed by the 20% combined loss of 2000 and 2001. It is a real-time
experience of the example outlined above. This is why our recent
account balance results can appear to be a little discouraging.
There is also a temptation to make an inaccurate comparison of
401(k) results with those of an older IRA that has had no new
contributions. It would appear that the 401(k) hasn't done as
well, but this is only because those inbound contributions create
a moving target for calculating our percentage gains.
Fortunately, the Excel spreadsheet software in the Windows program
of everyone's computer offers a calculator for determining how
well you have been doing with your 401(k) investments. The "paste
function" on the same toolbar where you find the icon for
"print" will lead you to a selection of different financial
calculations. "IRR" is one of the options the computer
will calculate. You start by lining up the contribution amounts
(as negative numbers) on an Excel spreadsheet in a row of cells
for the years you have been a participant. In the last cell, insert
as a positive number the total value of your account as of
the end of last year. Move to an empty cell, go to the "paste
function" icon and click "IRR." Enter the line
of cells for which you want the calculation performed (i.e. A1:L1)
and click "OK."
Most people who have been contributing a consistent regular amount
for several years will find that their returns are in the 7-8%
range. This is not a bad return. Money compounding at this rate
doubles every ten years. The biggest mistake that some people
are making is to recall their amazing account balance at the end
of the March in 2000 and adopt the mindset that they have "lost"
by whatever today's lower account balance reflects. That extraordinary
market performance was a fluke, and too many future retirees made
the mistake of assuming that it was somehow locked in by some
kind of ratchet effect.
In the face of recent disappointments, calculating our IRR can
be reassuring. It generally indicates that we can do pretty well
using a "minimalist approach" to investment management.
Calculating our return with a tool that considers a steady stream
of contributions over time helps us avoid doing anything rash
like moving everything into cash.
Finally, we need to recall that retirement plan contributions
include money that would otherwise have disappeared in taxes.
For most families or single people, the last few dollars of income
contributed to the plan would otherwise have been taxed at roughly
36% (state and federal). Now, go back and reduce your contribution
amount in your IRR calculation by 36% to reflect your actual cost
in take- home pay of those contributions. This raises your return
from 7% to 16%. The lesson? It doesn't take a super-heated stock
market to make you look like a genius. Just use the right measuring
tool.
The securities markets are subject to the risks
of fluctuating prices and the uncertainty of rates of return and
yields inherent in investing and past performance is no guarantee
of future results.
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