Investment Stupidity, Part 2.

This is a missive about financial stupidity. If you think I am giving you either tax advice or investment advice, then you are sorely mistaken and you should find someone else to bother. If you want to learn about an alternative to stupidity, then you are welcome to read on.

If you think that the rates of return cited in this missive are outrageous and completely unattainable, or require a Ponzi scheme to obtain, then you should return to watching some nonsensical “reality” show on television. The returns cited were obtained for real-money portfolios using real-world investment strategies.

Recently, a friend came to me seeking my thoughts about a predicament in which he found himself. He is aged 60 years, has a retirement account of about $300,000, which is contained in a conventional IRA, and a ROTH IRA in which he has about $12,000. He wants to withdraw $1,000 per month from his retirement assets, wants to draw Social Security at aged 62, wants to preserve capital, and wants to grow the net value of his retirement account. Of course, his requirements are mutually incompatible and, he has already made a serious mistake. Throughout the following discussion of his situation, it is assumed that the friend is married and that each will maintain a ROTH IRA and the combined ROTH IRAs will be considered as a single unit.

As to the mistake: by starting his draw on Social Security at age 62, he has immediately taken a 25% reduction in his monthly income from that institution for the rest of his life. If he were to refund the amount already withdrawn to the Social Security Administration, and continue to work until he was 65, he would establish a situation in which he could have an income from Social Security at 100% level, possibly increase the actual amount of the eventual monthly income from Social Security and, perhaps, substantially reduce his anxiety about his retirement.

As to the conventional IRA: even if the funds were in some other type of qualified retirement account, the law allows him to roll the conventional IRA, or the qualified retirement account, into a ROTH IRA. Of course, he would incur a substantial tax bill as a result and he would not be able to withdraw any amount from that ROTH IRA for five years. This would not be an entirely negative proposition as he should work until at least 65 in order to shore up his Social Security account. As to the taxes on his retirement account, those would easily be regained depending upon how aggressive he would be willing to be in his investment strategy. Even if he were to invest the assets in his ROTH IRA only modestly aggressive and have annual returns of about 10%, he would regain the entirety of the assessed tax before the end of his 63 year, by which time he should still be gainfully employed. It should not be missed that the assets in the ROTH IRA grow tax free forever and all distributions after the first five years of the life of the IRA would be free of taxes. If he did not withdraw any amount from the ROTH IRA until year 20, by which time he would be 80, the ROTH IRA would have in excess of $1,500,000 in nominal dollars and a present value of about $706,000 assuming an average annual inflation rate of 3.74%. If he made no withdrawals until after his 86th birthday, his account would exceed $1,000,000 in present day dollars.

Of course, if he could do no better than 10% per year in average annualized returns, then he should just punch out and go home. By the way, since 1970, Chevron has given average annualized returns of about 12.7%. I would not consider Chevron to be a particularly risky company into which one could invest. If my friend were to invest his ROTH IRA at a modest rate of 12.5%, his portfolio would be in exceed $1,000,000, in present day dollars, before his seventy ninth birthday and would exceed $2,000,000, in present day dollors, before his eighty sixth birthday. Even before his seventieth birthday, he could withdraw his requisite $12,000 per year, in present day dollars, or about 2.4% of the total value of his ROTH IRA for the rest of his life and never run out of money. It is simple to show that, starting on his seventieth year, he could withdraw $25,000 per year, in present day dollars, and never run out of money. Again, if he can do no better than 12.5% per year in the stock market, he is doing something seriously wrong.

I would consider the lower limit of a modestly aggressive investment strategy to give an average annualized return of no less that 16%. In this case, his ROTH IRA would exceed $1,000,000, in present day dollars, before his seventy fourth birthday, $2,000,000, in present day dollars, before his eightieth birthday, and $4,000,000 before his eighty sixth birthday. All, of course, tax free.

Now, let us consider the case in which he would not, or could not, roll over his conventional IRA, or qualified retirement plan, into a ROTH IRA. In this case, my friend could simply take distributions from that conventional IRA starting at age 59 1/2, pay the taxes on the distributions, and then put the after taxes proceeds, not to exceed $12,000 for 2012 and $13,000 for 2013, until he reached the age of 72. The age of 72 is critical as he will have passed what I term a “time horizon” in his investment strategy. After age 72, he could simply pocket the required minimum distributions from the conventional IRA and go on a vacation. Such vacations would probably benefit him and all around him as none would then be at risk of going insane as a result of his hyperventilating anxiety attacks. I would apply the rule that this ROTH IRA is a “just in case” account should he fall into dire straits and need some money. Of course, he could not withdraw any of the funds from the ROTH IRA until he was past the age of 65, since by then the five-year limit would have expired.

Suppose that he had his conventional IRA invested at a modest investment vehicle that provided him with a 10.0% per year return. Further, assume that the assets in the ROTH IRA are invested in a similar vehicle also providing a 10.0% per year return. The value of the ROTH IRA in both nominal and present day dollars is given in the following Table I. In Table I, the start of the present year, which is 2012, is assumed to start on year labeled “0” upon which the individual is of age 60 years. The present value is computed as at the beginning of the year labeled “0”.

Table I: The value of the ROTH IRA assuming that the required minimum distributions, after taxes, from a conventional IRA were deposited into a ROTH IRA for the first twelve years of the investment strategy. It is assumed that both the Conventional IRA and the ROTH IRA are invested in a conservative investment vehicle that returns a 10% per year yield. The value at the beginning of the relevant year is given in the column labeled “Begin. Value”, the value of the ROTH IRA at the end of that same year is given in the column labeled “Ending Value”, and the value of the ROTH IRA in present day dollars, which is for year 2012, is given in the column labeled “End. Val. {P.V.}”.
Year   Age Begin. Value Ending Value End. Val. {P.V.}
-1   59 12,000 13,200 13,200
0   60 25,200 27,720 25,757
1   61 40,720 44,792 40,120
2   62 54,573 60,031 51,831
3   63 70,695 77,765 64,722
4   64 89,442 98,386 78,932
5   65 111,109 122,219 94,518
6   66 135,219 148,741 110,882
7   67 161,741 177,915 127,849
8   68 190,915 210,007 145,469
9   69 223,007 245,308 163,796
10   70 258,308 284,138 182,884
11   71 297,138 326,852 202,792
12   72 339,852 373,838 223,581
13   73 373,838 411,221 237,073
14   74 411,221 452,343 251,379
15   75 452,343 497,578 266,548
16   76 497,578 547,336 282,632
17   77 547,336 602,069 299,687
18   78 602,069 662,276 317,771
19   79 662,276 728,504 336,946
20   80 728,504 801,354 357,279
21   81 801,354 881,489 378,838
22   82 881,489 969,638 401,698
23   83 969,638 1,066,602 425,938
24   84 1,066,602 1,173,262 451,640
25   85 1,173,262 1,290,589 478,894
26   86 1,290,589 1,419,647 507,792
27   87 1,419,647 1,561,612 538,434
28   88 1,561,612 1,717,773 570,924
29   89 1,717,773 1,889,551 605,376
30   90 1,889,551 2,078,506 641,906
31   91 2,078,506 2,286,356 680,641
32   92 2,286,356 2,514,992 721,713
33   93 2,514,992 2,766,491 765,263
34   94 2,766,491 3,043,140 811,441
35   95 3,043,140 3,347,454 860,406

It should not go unnoticed that after the twelfth year, the individual would be drawing between $12,000 and $15,000 per year, in present day dollars, net of taxes, which would satisfy his requirement of withdrawing $1,000 per month from the retirement portfolio.

Whilst the results in Table I appear to be favourable, let us consider the situation of both the conventional IRA and the ROTH IRA if these were in conservative investment vehicles providing an average annualized return of 12.5%. After the twelve-year time horizon has passed, the individual will received an annual required minimum distribution of about $20,000 to $33,000 per year, in present day dollars, net of taxes. The values of the ROTH IRA through age 95 of the individual, assuming no withdrawals are taken, are given in Table II.

Table II: The value of the ROTH IRA assuming that the required minimum distributions, after taxes, from a conventional IRA were deposited into a ROTH IRA for the first twelve years of the investment strategy. It is assumed that both the Conventional IRA and the ROTH IRA are invested in a conservative investment vehicle that returns a 12.5% per year yield.
Year   Age Begin. Value Ending Value End. Val. {P.V.}
-1   59 12,000 13,500 13,013
0   60 25,500 28,688 26,656
1   61 41,688 46,898 42,007
2   62 57,129 64,270 55,492
3   63 75,679 85,139 70,859
4   64 97,914 110,153 88,373
5   65 123,153 138,548 107,146
6   66 151,548 170,491 127,096
7   67 183,491 206,427 148,338
8   68 219,427 246,856 170,994
9   69 259,856 292,338 195,198
10   70 305,338 343,505 221,095
11   71 356,505 401,068 248,838
12   72 414,068 465,827 278,597
13   73 465,827 524,055 302,123
14   74 524,055 589,562 327,634
15   75 589,562 663,257 355,300
16   76 663,257 746,164 385,303
17   77 746,164 839,435 417,838
18   78 839,435 944,364 453,121
19   79 944,364 1,062,410 491,384
20   80 1,062,410 1,195,211 532,877
21   81 1,195,211 1,344,612 577,874
22   82 1,344,612 1,512,689 626,671
23   83 1,512,689 1,701,775 679,588
24   84 1,701,775 1,914,497 736,974
25   85 1,914,497 2,153,809 799,206
26   86 2,153,809 2,423,035 866,692
27   87 2,423,035 2,725,914 939,877
28   88 2,725,914 3,066,653 1,019,242
29   89 3,066,653 3,449,985 1,105,309
30   90 3,449,985 3,881,233 1,198,643
31   91 3,881,233 4,366,387 1,299,859
32   92 4,366,387 4,912,186 1,409,621
33   93 4,912,186 5,526,209 1,528,653
34   94 5,526,209 6,216,985 1,657,735
35   95 6,216,985 6,994,108 1,797,717

Even with the assets of both the conventional IRA and the ROTH IRA invested at a modest average annual yield of 12.5%, the ROTH IRA contains a sizable and comfortable amount of money for late in retirement. Of course, should any of the money be withdrawn, that margin that is available late in the retirement years will be substantially reduced.

The natural question to ask is: would a 15 year time horizon make a substantial difference in the value of the ROTH IRA over employing only a 12 year time horizon. If the after-taxes required minimum distributions were transferred to the ROTH IRA for the entire 15 year time horizon rather than for a 12 year time horizon, the value of the ROTH IRA at the 35th year would be $1,932,122, which is a mere $134,427 benefit over the 12 year time horizon strategy. It would be better to take the required minimum distributions after the expiration of the 12 year time horizon and take the wife to Saint Johns.

When the investment strategy starts to yield an average annualized return in excess of about 12.5%, both the risk and the volatility associated with the investment will rise substantially. If one were to attempt to obtain returns in excess of about 12.5% in the conventional IRA, it is entirely likely that assets will be liquidated to satisfy the required minimum distribution for any given year at a time that the assets were significantly undervalued. Such a move could severely impair the ability of the conventional IRA to regain enough value to allow resumption of the normal and expected values of the required minimum distributions. However, the ROTH IRA is found in a completely different situation.

The ROTH IRA is considered an asset of last resort. The corpus of that asset will not be accessed unless the individual is living on the streets, and he finds all of the dumpsters in the city completely devoid of any type of nourishment no matter how foul or decayed. Thus, the corpus of the ROTH IRA will readily survive the volatility inherent in the more aggressive investment strategies and, if proper weighting techniques are employed, will even easily survive complete loss as to one or two companies the shares of which were held in the ROTH IRA. Given this basis, let us consider the circumstance in which the conventional IRA is invested in a vehicle that provides a 12.5% average annualized yield and the ROTH IRA is invested in investment strategies yielding 16%, 22%, and 25.9%. For those doubters, these investment strategies actually exist and these are actual long-term annual returns, dating to before 1998, for these investment strategies. The results are to be found in Table III, for the 16% case, Table IV, for the 22% case, and Table V, for the 25.9% case. It is essential to remember that these valuations are obtained tax free and all distributions are obtained tax free.

Table II: The value of the ROTH IRA assuming that the required minimum distributions, after taxes, from a conventional IRA were deposited into a ROTH IRA for the first twelve years of the investment strategy. It is assumed that the Conventional IRA is invested using a strategy that provides a 12.5% per year average annual yield and the ROTH IRA is invested using a strategy that provides a 16.1% yield.
Year   Age Begin. Value Ending Value End. Val. {P.V.}
-1   59 12,000 13,500 13,013
0   60 25,932 29,174 27,108
1   61 43,107 48,495 43,437
2   62 60,278 67,813 58,550
3   63 81,391 91,565 76,208
4   64 107,271 120,680 96,818
5   65 137,541 154,734 119,664
6   66 172,685 194,271 144,823
7   67 213,488 240,174 172,588
8   68 260,859 293,467 203,281
9   69 315,858 355,340 237,266
10   70 379,711 427,175 274,948
11   71 453,844 510,575 316,780
12   72 539,913 607,402 363,270
13   73 626,839 705,194 406,551
14   74 727,760 818,730 454,989
15   75 844,930 950,546 509,198
16   76 980,964 1,103,584 569,866
17   77 1,138,899 1,281,261 637,762
18   78 1,322,261 1,487,544 713,748
19   79 1,535,145 1,727,039 798,787
20   80 1,782,304 2,005,092 893,958
21   81 2,069,255 2,327,912 1,000,467
22   82 2,402,405 2,702,705 1,119,667
23   83 2,789,192 3,137,841 1,253,069
24   84 3,238,252 3,643,033 1,402,364
25   85 3,759,610 4,229,562 1,569,447
26   86 4,364,908 4,910,521 1,756,438
27   87 5,067,658 5,701,115 1,965,707
28   88 5,883,551 6,618,994 2,199,909
29   89 6,830,802 7,684,653 2,462,015
30   90 7,930,561 8,921,882 2,755,349
31   91 9,207,382 10,358,305 3,083,633
32   92 10,689,770 12,025,992 3,451,029
33   93 12,410,823 13,962,176 3,862,198
34   94 14,408,966 16,210,087 4,322,356
35   95 16,728,809 18,819,910 4,837,339

If one is willing to assume a somewhat higher level of risk and its attendant volatility by using an investment strategy that yields a 22% per year return, then the values of the ROTH IRA for each year through until the individual is of age 95 years are as given in Table III.

Table III: The value of the ROTH IRA assuming that the required minimum distributions, after taxes, from a conventional IRA were deposited into a ROTH IRA for the first twelve years of the investment strategy. It is assumed that the Conventional IRA is invested using a strategy that provides a 12.5% per year average annual yield and the ROTH IRA is invested using a strategy that provides a 22.0% yield.
Year   Age Begin. Value Ending Value End. Val. {P.V.}
-1   59 12,000 13,500 13,013
0   60 26,640 29,970 27,848
1   61 45,501 51,188 45,849
2   62 65,742 73,960 63,857
3   63 91,613 103,065 85,779
4   64 124,544 140,112 112,408
5   65 164,943 185,561 143,504
6   66 214,231 241,010 179,666
7   67 274,362 308,657 221,799
8   68 347,721 391,187 270,970
9   69 437,220 491,873 328,431
10   70 546,409 614,710 395,654
11   71 679,618 764,571 474,369
12   72 842,134 947,401 566,613
13   73 1,027,404 1,155,830 666,347
14   74 1,253,433 1,410,112 783,635
15   75 1,529,188 1,720,337 921,568
16   76 1,865,610 2,098,811 1,083,779
17   77 2,276,044 2,560,549 1,274,543
18   78 2,776,773 3,123,870 1,498,884
19   79 3,387,664 3,811,122 1,762,713
20   80 4,132,950 4,649,568 2,072,981
21   81 5,042,198 5,672,473 2,437,861
22   82 6,151,482 6,920,417 2,866,965
23   83 7,504,808 8,442,909 3,371,600
24   84 9,155,866 10,300,349 3,965,059
25   85 11,170,156 12,566,426 4,662,976
26   86 13,627,591 15,331,040 5,483,739
27   87 16,625,661 18,703,869 6,448,970
28   88 20,283,306 22,818,720 7,584,098
29   89 24,745,634 27,838,838 8,919,028
30   90 30,189,673 33,963,382 10,488,929
31   91 36,831,401 41,435,326 12,335,158
32   92 44,934,309 50,551,098 14,506,355
33   93 54,819,858 61,672,340 17,059,720
34   94 66,880,226 75,240,254 20,062,520
35   95 81,593,876 91,793,110 23,593,864

By allowing a very high level of risk and its attendant volatility in using an investment strategy that yields a 25.4% per year return, then the values of the ROTH IRA for each year through until the individual is of age 95 years are as given in Table IV.

Table IV: The value of the ROTH IRA assuming that the required minimum distributions, after taxes, from a conventional IRA were deposited into a ROTH IRA for the first twelve years of the investment strategy. It is assumed that the Conventional IRA is invested using a strategy that provides a 12.5% per year average annual yield and the ROTH IRA is invested using a strategy that provides a 25.4% yield.
Year   Age Begin. Value Ending Value End. Val. {P.V.}
-1   59 12,000 13,500 13,013
0   60 27,048 30,429 28,275
1   61 46,918 52,783 47,278
2   62 69,066 77,700 67,086
3   63 98,017 110,270 91,775
4   64 135,689 152,651 122,467
5   65 183,154 206,049 159,348
6   66 242,676 273,010 203,521
7   67 317,315 356,980 256,524
8   68 410,913 462,278 320,214
9   69 528,285 594,321 396,837
10   70 675,470 759,904 489,107
11   71 860,039 967,544 600,302
12   72 1,091,489 1,227,925 734,386
13   73 1,368,727 1,539,818 887,720
14   74 1,716,384 1,930,932 1,073,068
15   75 2,152,346 2,421,389 1,297,115
16   76 2,699,042 3,036,422 1,567,941
17   77 3,384,598 3,807,673 1,895,313
18   78 4,244,286 4,774,822 2,291,038
19   79 5,322,335 5,987,627 2,769,387
20   80 6,674,208 7,508,484 3,347,610
21   81 8,369,457 9,415,639 4,046,562
22   82 10,495,299 11,807,211 4,891,449
23   83 13,161,105 14,806,243 5,912,740
24   84 16,504,026 18,567,029 7,147,268
25   85 20,696,048 23,283,054 8,639,555
26   86 25,952,844 29,196,950 10,443,418
27   87 32,544,867 36,612,975 12,623,912
28   88 40,811,263 45,912,671 15,259,674
29   89 51,177,324 57,574,489 18,445,759
30   90 64,176,364 72,198,409 22,297,072
31   91 80,477,160 90,536,805 26,952,504
32   92 100,918,359 113,533,154 32,579,950
33   93 126,551,622 142,370,575 39,382,358
34   94 158,695,734 178,532,701 47,605,048
35   95 199,004,451 223,880,007 57,544,563

Investment strategies exist that will provide a long-term average annual rate of return of 28.7%. Using these types of strategies will yield a ROTH IRA with a valuation in excess of one-half billion dollars, in nominal values, and in excess of $134,000,000 in present day values. Of course, when one reaches these valuations, investments into individual companies may be sufficiently large as to move the market value of the relevant shares. It may very well be that the smaller portfolios can realize annual growth rates in excess of 27% to 28% but these growth rates will be increasingly difficult to maintain for larger portfolios.

Then there is the Magic Formula Investing of Joel Greenblatt ….

I hope that this helps.

Nathan A. Busch

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