Thursday, October 15, 2009

Are Stocks The Best Investment?

"One of the loudest critics of the idea of investing in stocks for the long run is Rob Arnott, chairman of money manager Research Affiliates in Newport Beach, Calif. Mr. Arnott, a veteran financial analyst and market pundit, recently wrote an article for the Journal of Indexes that highlighted that bonds have outperformed stocks over long stretches. Mr. Arnott found that from February 1969 through February this year, investors in 20-year Treasurys, rolling to the nearest 20-year bond and reinvesting the income, would have beaten investors in the S&P 500 - a 40-year record of bonds beating stocks." The Wall Street Journal, September 2, 2009, page R1.

Well, OK then. Bonds are better than stocks for the long run. But are bonds good enough?

For the 40-years ending in 2008, the 20-year Treasury returned about 7.73% on average, and the inflation rate measured by the CPI-U (which many experts claim greatly understates true inflation) was 4.55% on average.

So how did the lucky investor who earned that generous 7.73% for the past 40-years actually do? Not very well, as it turns out, as detailed below:

Amount invested (say): $1,000, times 7.73% rate of return, equals $77.30 in annual interest, less income taxes (say 41.14%) in the amount of $31.80, equals interest after taxes of $45.50, less 4.55% inflation in the amount of $45.50, equals the return after taxes and inflation of exactly zero.

Please note that the government has the ability to shear sheep - I mean citizens - two ways; taxation and inflation.

In the example above, income taxes took 41.14% of your return and inflation took the remaining 58.86%. The government got it all!

I used a tax rate of 41.14% in this example because, in 1990, while I was still working, my incremental tax rate was 33% (it would have been 50% except for the Tax Reform Act of 1986) and I believe that the tax rate I used is reasonably representative for this 40-year period.

But if bonds are better than stocks for the long run and if the government takes most, if not all, your investment return through taxes and inflation, how can you ever afford to retire?

Well, if you plan to work for thirty years and plan to be retired for thirty years, all you have to do is save at least half of the money you earn while you are working.