Compound interest’s effect on $100 is explosive
Reprinted courtesy of MarketWatch.com.
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The following questions were generated in response to my recent article describing how to turn $3,000 (or alternatively $365 a year) into $50 million.
Q. I’m excited to read your plan for turning $365 a year into $50 million for a newborn child. I’ve got a new granddaughter, and all I can put away is $100 a year. Where can I invest that amount in a small-cap-value fund?
A. For starters, I assume you know you won’t get the same result from $100 a year as from $365 a year. But the results over a lifetime can still be impressive. You can invest any amount, no matter how small, in any of more than 100 commission-free ETFs offered by TD Ameritrade.
For investors with $1,000 or more to start, my choice would be the SPDR S&P 600 small-cap-value ETF SLYV, -1.55% available commission-free at Schwab. I like it for its relatively low expenses, its low average company size and its low price-to-book ratio.
Q. What do you think of the Guggenheim S&P SmallCap 600 Pure Value (RZV) ETF? It holds smaller companies at a substantially lower price-to-book ratio. Is this worth considering despite its higher expenses?
A. In a word, yes. The Guggenheim ETF RZV, -1.46% is available commission-free at Schwab, though it’s not on their Select List. I think this ETF will be a long-term winner. Its average holding is 40% smaller than other small-cap-value ETFs, and the price-to-book ratio is about 30% lower.
But there’s a major drawback: extreme volatility. According to Morningstar, RZV was among the very worst small-cap-value performers in 2007, 2008 and 2011 (bad years for this asset class). On the other hand it was No. 1 in the very good years of 2009 and 2013.
If you want to invest in RZV, I suggest you consider splitting your investment between RZV and SLYV.
Q. If I make a $50 million gift to my grandson, don’t you think his parents will be envious and resentful unless I do the same thing for them?
A. If you were actually giving $50 million to your grandson and nothing to his parents, they would have reasonable cause to be upset.
But if you follow my suggestion, you are not giving $50 million to anybody. You are giving your grandson $3,000 along with the theoretical opportunity to eventually turn it into $50 million.
Of that $50 million (if it ever grows to that amount), $49,997,000 will not come from you. It will be the result of the investments that you (and eventually your grandson) make with that money.
Even if it all works out as you hope, it won’t be like winning the lottery. By the time your gift grows to be worth even $5 million, your grandson is likely to be well into his 60s.
If you are concerned about his parents’ reaction, you could give them an equal amount and let them do whatever they want with $3,000.
Q. I worry that if I set up my granddaughter with a $50 million plan, she may become lazy or complacent while expecting a large inheritance. How can I prevent this from happening?
A. Ultimately, you cannot control the attitudes or behavior of your heirs. However, as you can see in my answer to the previous question, your granddaughter is unlikely to have a ton of money for a very long time.
In fact, with a 12% return, when she’s 65 her IRA should be worth about $668,000 in 2015 dollars.
Perhaps the most important message you can pass along is the intention behind your contribution. The best way to do that is to have a talk with her when she’s old enough to understand.
Q. What about adding international and emerging-market small-cap value to the portfolio?
A. It’s possible that more diversification will improve the returns, but there’s no guarantee. Over the last 15 years, U.S. and international small-cap-value each compounded at 11.1%, and emerging markets small-cap compounded at 12.1%. (In the same period, the Standard & Poor’s 500 Index compounded about 5%.)
Q. My children are 4 and 6. I like your plan, but how much do I have to put in now to make it reach $50 million?
A. If you accept the assumptions that each of your children will leave the money to compound at 12% until age 65, then start withdrawing 5% of the balance each year until age 95, you can find the answers to your question in a large table of values that’s available on my website.
In your case, you would have to invest $4,721 now for your 4-year-old and $5,921 now for your 6-year-old.
Q. How can I keep my child from cashing out the account?
A. This question is more about your relationship with your child than it is about investing.
While you are alive, you could neglect to tell your child about the account. But that would deprive you of the excellent teaching and learning opportunities that go along with this plan.
After your death, the only sure way to keep the money away from your child is to set up a Crummy trust with strict rules. This would be expensive and would require a variable annuity instead of the much more tax-efficient Roth IRA.
Q. If I give this money to my grandson, will it reduce what he gets in college financial aid?
A. It could.
Normally, college aid officials will regard your grandson’s assets as money that he can afford to contribute toward the cost of his education. They will probably take a similar attitude toward some percentage of the assets owned by your grandson’s parents.
But if the money is registered in your name, then it belongs to you and probably will be invisible to the people who determine financial aid. That’s a good reason to consider a delay in moving the money into an IRA.
Q. Where can I learn more on this whole topic?
A. I have recorded a podcast called How to turn $3,000 into $50 million. This presentation outlines all the steps that parents and grandparents should consider in setting up this amazing strategy.
Richard Buck contributed to this article.