GEK2507 1 Frederick H. Willeboordse [email protected] Compound & Prosper!

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GEK2507Frederick H. [email protected]

Compound & Prosper!

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Accumulating Assets

Lecture 11

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Mutual Funds, Index Funds and ETFs

Buy or Rent?

Making the million … is easy! Or is it???

Compound …. Compound …. Compound …. Compound …. Compound …. Compound …. Compound ….

Basically, there are two simple ways to accumulate wealth that are practical for most of us. Real Estate and Stocks. Let us have a look at both of them before jumping to the last item.

Buy: 700,000Rent: 2,000

Today’s Lecture

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There are roughly 5 ways to invest in stocks:

• Buy and select stocks yourself• Buy stocks on advice of an advisor/personal banker• Buy a mutual fund (unit trust)• Buy an index fund• Buy Exchange Traded Funds (ETF)

Note: All the comments are based on the assumption that we are average investors at best…

Investing in Stocks

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Buy and select stocks yourself

Nowadays with cheap internet broking readily available, selecting and buying stocks is very easy (especially in countries like the US where you can buy single shares).

However, this is a risky venture! It is very difficult for an individual to beat the market (and in fact most of the professionals as well).

Investing in Stocks

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Buy stocks on advice of an advisor/personal banker

Unless one has very large sums to invest, it is rather unlikely to be assigned a sufficiently qualified personal banker.Personal banking is very expensive …. and hence not very suitable for the average investor.

Investing in Stocks

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Buy a mutual fund (unit trust)

In a mutual fund or unit trust, the money of thousands of individuals is pooled and then invested by the fund manager according to the nature of the fund.

Since ‘shares’ only indicate how much is contributed to the pool, it is not necessary to buy entire shares and one can buy e.g. 0.1234 shares.

In fact, usually one would buy for a round sum e.g. $100 rather than a certain number of shares.

Mutual Funds are pretty good, but!, there are significant costs.

Investing in Stocks

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Buy an index fund

Index funds are a special type of Mutual fund that exactly track an index.Therefore, their performance will almost exactly be that of the market.

A good way to invest with a hands-off approach. The costs are generally low and risks can be much lower as well in the case of broad-based indices.

Well, the marketing asalways moves me to tears..

Investing in Stocks

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Buy Exchange Traded Funds (ETF)

Exchange Traded Funds are shares listed on the stock market that (almost) exactly track an index.Since they are actual shares, they can be bought and sold any time but only as entire shares.

Pro: Basically all the advantages of Index Funds but easy to trade. Con: For small amounts of money, however, the trading costs may not be worth it. A famous ETF is the so-called Spider which tracks the US SP500 index.

ETF

Investing in Stocks

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Mutual Funds vs Index Funds:

Investing is a zero sum game as with regards to the overall market performance. If one investor outperforms the market another will underperform it by definition.

The big problem with Mutual Funds is their costs. E.g. most mutual funds in Singapore have a 5% upfront charge plus a 1.5% annual fee.Index Funds (in the US) usually only charge about 0.27%

Investing in Stocks

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Mutual Funds vs Index Funds:

Let us see what this means for 20 years IF the mutual funds perform as well as the market.

A B C D E F2 Mutual F Load 5% Annual 1.50%3 Index F Load 0% Annual 0.27%4 Market 9.80%56 Year New Inv. Total MF Total IF7 1 1,200.00 1,140.00 1,200.008 2 1,200.00 2,372.94 2,514.049 3 1,200.00 3,706.41 3,952.9710 4 1,200.00 5,148.59 5,528.6411 5 1,200.00 6,708.36 7,254.0512 6 1,200.00 8,395.29 9,143.4513 7 1,200.00 10,219.76 11,212.4014 8 1,200.00 12,192.98 13,477.9715 9 1,200.00 14,327.07 15,958.8616 10 1,200.00 16,635.16 18,675.5117 11 1,200.00 19,131.42 21,650.3518 12 1,200.00 21,831.20 24,907.9019 13 1,200.00 24,751.10 28,475.0320 14 1,200.00 27,909.06 32,381.1621 15 1,200.00 31,324.49 36,658.5222 16 1,200.00 35,018.37 41,342.3823 17 1,200.00 39,013.42 46,471.3724 18 1,200.00 43,334.18 52,087.7925 19 1,200.00 48,007.22 58,237.9726 20 1,200.00 53,061.25 64,972.64

=E7*(1+$F$4)*(1-$F$2)+$D8*(1-$D$2)

=F7*(1+$F$4)*(1-$F$3)+$D8

Investments made at end of year.

A difference of nearly12,000 dollars! Or morethan 22%!!!

Investing in Stocks

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Mutual Funds vs Index Funds:

Ergo: If the Mutual Funds performs as well as the index, the index funds will do better by more than 22% in this example.However, on average, Mutual Funds actually underperform the index!!! Hence, on average, the difference is even bigger!

Percentage of Stock Funds Outperformed by Index(Last 10 years, US, Funds investing in large companies)

Investment Style Value Blend Growth

Percentage 76% 91% 86% Ouc

hhhh

!

Investing in Stocks

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Mutual Funds vs Index Funds:

In conclusion, historically speaking, the simplest and safest way to invest in stocks is through sufficiently broad based index funds (or for that matter exchange traded funds).

Percentage of Stock Funds Outperformed by Index(Last 10 years, US, Funds investing in large companies)

Investment Style Value Blend Growth

Percentage 76% 91% 86% Thi

s hu

rts.

Investing in Stocks

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We all would like to own our own homeand there’s of course nothing wrongwith that.

The question being: “Is this the best way to make money?”

Surely paying rent can’t help to make me rich. If I buy a flat, the mortgage is for my own property. It’s like paying to myself. And, appreciation of the flat is on the full value not just on the part I’ve already paid for. Or is it?

Excel to the rescue!

Buy or Rent?

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This looks like quite a complex problem, hence, as always, let’s take it step by step and start with a list of things we need to take into account.

• Rent as a percentage of the Price of the Flat/House• Mortgage Rate• Appreciation of Flat/House• Return on alternative investment (e.g. Stocks)

Do we need the price of the Flat/House?Do we need inflation?

Buy or Rent?

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A B C D E F G H I23 Rent % 3.00% Price 100,0004 Mortgage Rate % 6.00% Term 305 Appreciation of Flat % 6.00%6 Return on other investment % 10.00% Mortgage 7265789 Year Rent Mortgage Value of Flat Value of Inv.

1011 1 3000 7265 100000 426512 2 3180 7265 106000 877613 3 3371 7265 112360 1354814 4 3573 7265 119102 1859515 5 3787 7265 126248 2393216 6 4015 7265 133823 2957517 7 4256 7265 141852 3554218 8 4511 7265 150363 4185019 9 4782 7265 159385 4851820 10 5068 7265 168948 5556737 27 13648 7265 454938 25820438 28 14467 7265 482235 27682339 29 15335 7265 511169 29643540 30 16255 7265 541839 317088

=PMT($F$4,$I$4,-$I$3,0)

=F11*$F$3=F11*$F$5

=E12-D12+G11*(1+$F$6)

Yearly basis!

Buy.

These are fairly reasonablepercentages.

Value of Investment Account if difference between Mortgage and Rent is saved.

Buy or Rent?

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A B C D E F G H I23 Rent % 3.00% Price 100,0004 Mortgage Rate % 6.00% Term 305 Appreciation of Flat % 4.00%6 Return on other investment % 10.00% Mortgage 7265789 Year Rent Mortgage Value of Flat Value of Inv.

1011 1 3000 7265 100000 426512 2 3120 7265 104000 883613 3 3245 7265 108160 1374014 4 3375 7265 112486 1900415 5 3510 7265 116986 2466016 6 3650 7265 121665 3074117 7 3796 7265 126532 3728418 8 3948 7265 131593 4432919 9 4106 7265 136857 5192220 10 4270 7265 142331 6010937 27 8317 7265 277247 36844738 28 8650 7265 288337 40390639 29 8996 7265 299870 44256540 30 9356 7265 311865 484731 Don’t Buy.

All we did is change the appreciation from 6% to 4%.

Buy or Rent?

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A B C D E F G H I23 Rent % 3.00% Price 100,0004 Mortgage Rate % 6.00% Term 305 Appreciation of Flat % 5.00%6 Return on other investment % 10.00% Mortgage 7265789 Year Rent Mortgage Value of Flat Value of Inv.

1011 1 3000 7265 100000 426512 2 3150 7265 105000 880613 3 3308 7265 110250 1364414 4 3473 7265 115763 1880115 5 3647 7265 121551 2429916 6 3829 7265 127628 3016517 7 4020 7265 134010 3642618 8 4221 7265 140710 4311219 9 4432 7265 147746 5025620 10 4654 7265 155133 5789337 27 10667 7265 355567 31718638 28 11200 7265 373346 34496939 29 11760 7265 392013 37497040 30 12348 7265 411614 407384

Buy ???Buy

All we did is change the appreciation from 6% to 5%.

?

Buy or Rent?

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A B C D E F G H I23 Rent % 3.00% Price 100,0004 Mortgage Rate % 6.00% Term 305 Appreciation of Flat % 8.00%6 Return on other investment % 10.00% Mortgage 7195789 Year Rent Mortgage Value of Flat Value of Inv.

1011 1 3000 7195 100000 419512 2 3240 7195 108000 856913 3 3499 7195 116640 1312114 4 3779 7195 125971 1784915 5 4081 7195 136049 2274716 6 4408 7195 146933 2780817 7 4761 7195 158687 3302318 8 5141 7195 171382 3837819 9 5553 7195 185093 4385820 10 5997 7195 199900 4944137 27 22189 7195 739635 10297638 28 23964 7195 798806 9650539 29 25881 7195 862711 8746840 30 27952 7195 931727 75458

Buy !!!!Buy

All we did is change the appreciation from 6% to 8%.

Buy or Rent?

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So should we buy or rent?

You decide!

I’d say, probably yes unless we either expect appreciation to be very low or stock market gains to be very high. Both not very likely in the long run in an advanced economy.

In any case, whether to buy or rent depends on many factors and is in that sense a very complex decision.

Buy or Rent?

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By now, you might have guessed it. The ‘secret’ to becoming a millionaire is both, a silly AND a serious matter.

It’s all about compounding!

• The silly part: A million in 45 years is worth less thana million today.

• The serious part: It can actually be done even when compensating for inflation.

Finale

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First, let’s see how much a million is actually worth in 45 years:

$212,659=PV(0.035,45,0,-1000000)

Still, 212,659 dollars is not bad at all! But I want a real million:

Finale

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How many dollars do we need in 45 years to have the same as 1 million dollars now?

$4,702,359=FV(0.035,45,0,-1000000)

We’ll need 4,702,359 million. IMPOSSIBLE!!!!

(Same formula with P->F)

Finale

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A letter to Bill Gates!

Dear Bill,

I would like to be a millionaire. Could you kindly please transfer $1,000,000 into my account as soon as possible.

Thank you,

Frederick

P.S. Microsoft makes my favorite software. Honestly!

Finale

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And he could reply

Dear Frederick,

If you like my software, try using Excel and think of compounding.

Yours,

Bill

P.S. Microsoft makes my favorite software too!

A Better Idea!

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Sigh! Ok let’s try …

Montly savings 100Average Return 12%Number of years 45

Total Savings $2,145,469

We’ll need 4,702,359 million….

That’s not so bad!

Finale

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Getting close …

Montly savings 220Average Return 12%Number of years 45

Total Savings $4,720,032

We’d have more than 4,702,359 million….if only …

Wow, but it would be nice if we could push this below 200 dollars.

Finale

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Montly savings 180 Total at end: 4,782,937Average Return 12%Number of years 45Yearly increase 5.00%

Year Savings Total1 2160 21602 2268 46873 2381 76314 2500 110475 2625 149986 2757 195557 2895 247968 3039 308119 3191 37700

Wait a moment! 200 dollars now is a lot more than 200 dollars in 45 years! We should take that into account.Let’s increase the monthly amount gradually.

There you go!~ Avg. return SP500last 60 years

Inflation plus 1.5%

Becoming a Millionaire

Possible, right!

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Conclusion:

By saving only a small amount every month, it is indeed possible to become a millionaire!

With patience of course…. Probably …

Becoming a Millionaire

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History could be wrong!

True but it’s the best we have, plus even if the average rate will turn out to be less, the power of compounding is still there. In any case it’s going to be a lot of money.

Pitfall

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Now:

Open an account with a reliable online broker and regularly invest small amounts in Spiders or a similar product until you retire.

In a little while:

Buy a Flat

Don’t put all your eggs in one basket. With your base money, do this:

If you have extra money to save, do this:

Enjoy yourself! Though saving a bit extra can’t hurt of course….

Think f

or yo

urse

lf!

Disclaimer: I’m not taking any responsibility for this!

My Thoughts

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Compound Long and Prosper!

All the best and good luck!

Key Point of the Course