AFP363E SECURITIES INVESTMENT & PORTFOLIO MANAGEMENT

SEMESTER I, 2009/2010
Tutorial 1: Case Study

Will You Be a Millionaire?

According to data available from The Statistical Abstract of the United States, 2006, per capita
income in the United States is $32,907. Income before taxes for the median (or the middle)
household is $43,318. There are presently about 112 million households in the United States.
Roughly 26.1% earn household income of $75,000 or more per year. A total of 16.9 million
households report income in excess of $100,000 per year. The cutoff point for the top 5% of
U.S. families according to income before taxes is $170,082 per year.
All of these numbers relate to income, not to wealth. What does the distribution of wealth
look like? The numbers may surprise you. For all families, the median level of wealth is only
$86,100. This includes financial and nonfinancial assets, like homes, cars, and so on, and adjusts
for debt, like mortgages. The median value of stocks and mutual funds is only $19,268. Among
families earning between $100,000 and $250,000 per year, only 37.1% own stocks and mutual
funds. It is perhaps surprising that high-income families accumulate relatively modest amounts
of stock and mutual fund wealth.
How much wealth do you consider is necessary to qualify as rich? Is it more than
$500,000? If so, fewer than one in twenty families in the U.S. command such a level of wealth.
Similarly, if an income in excess of $170,000 per year is required before you would consider
yourself rich, then only one in twenty families would enjoy a similar level of income in the U.S.
If the amount of wealth required exceeds $1 million, or the amount of income necessary income
exceeds $250,000, then you are well into the very narrow end of the wealth and income
distribution in the overall population. For arguments sake, let's assume that $1 million is the
amount of money required to become rich, although some might have a higher number in mind.
How do you build one million dollars of wealth? As shown, in the Table, an investment of
only $417 per year in a broadly diversified portfolio of common stocks made in a retirement
account has the potential to grow to $1 million over a 50-year period. This is only $34.75 per
month! If the investment is not made in a tax-deferred retirement account, then you would have
to increase the annual investment contributions to $1,227, or almost 3 times more. But most
people are hoping that they will not have to work for and save for 50 years. If you have 40 years
until your desired retirement date, it takes an annual retirement account stock investment of
$1,304. Note that a more conservative investment approach requires an annual retirement
account investment of $2,960 or $8,278 in bonds or money market investments, respectively.

Table

Annual Investment Needed to Become a Millionaire

Number of
Investing
Years
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
20
25
30
35
40
45
50

Stock Market Investments

12% Tax Free
$1,000,000
471,698
296,349
209,234
157,410
123,226
99,118
81,303
67,679
56,984
48,415
41,437
35,677
30,871
26,824
13,879
7,500
4,144
2,317
1,304
736
417

9% After Taxes
$1,000,000
478,469
305,055
218,669
167,092
132,920
108,691
90,674
76,799
65,820
56,947
49,651
43,567
38,433
34,059
19,546
11,806
7,336
4,636
2,960
1,902
1,227

Long-term Bond Market

Investments
9% Tax Free
$1,000,000
478,469
305,055
218,669
167,092
132,920
108,691
90,674
76,799
65,820
56,947
49,651
43,567
38,433
34,059
19,546
11,806
7,336
4,636
2,960
1,902
1,227

6.5% After Taxes

$1,000,000
484,262
312,576
226,903
175,635
141,568
117,331
99,237
85,238
74,105
65,055
57,568
51,283
45,940
41,353
25,756
16,981
11,577
8,062
5,694
4,060
2,914

Short-term Money Market

Investments
3.6% After
5% Tax Free
Taxes
$1,000,000
$1,000,000
487,805
491,159
317,209
321,616
232,012
236,898
180,975
186,109
147,017
152,285
122,820
128,155
104,722
110,084
90,690
96,053
79,505
84,848
70,389
75,700
62,825
68,094
56,456
61,674
51,024
56,186
46,342
51,444
30,243
34,999
20,952
25,334
15,051
19,055
11,072
14,705
8,278
11,556
6,262
9,204
4,777
7,406

The reality is that $1 million isnt what it used to be. Due to inflation, it wont be nearly as
valuable in 40 years. Over extended periods of time, taxes and inflation inhibit the building of
real wealth.
A.

Most investors do not contribute the same amount every year. Indeed, young investors
usually earn less money and therefore have less to contribute. As a person ages, income
rises because of job promotions and because of wage inflation. Using the Table,
determine how much money the following investor will have at retirement age. At age
25, the investor has 40 years until retirement. She opens a taxable stock brokerage
account and contributes $1,480 per year for 40 years (note that this contribution is
exactly half of the $2,960 shown in the table). At age 35, the investor gets a job with a
defined contribution plan and invests $4,144 per year in stocks for 30 years. At age 50,
the investor has only 15 years left until retirement. Taking a more conservative
approach, the investor starts investing an additional $20,677 every year into a taxable
bond account. How much money will this investor have at retirement?

B.

Why do so few individuals accumulate a significant amount of retirement wealth? Will

you? Use the data in the Table to show how.

SOLUTION
A.

A $1,480 contribution to a taxable stock account should build to $500,000 after 40 years.
The $4,144 annual contribution in the retirement plan will build to $1,000,000 if invested in
the stock market and contributions are made for 30 years. Lastly, the annual $20,677
investment in a taxable bond account should build to $500,000 in 15 years. Using this plan,
the investor can expect to retire with $2 million (=$500,000 + $1,000,000 + $500,000) of
investment assets.

B.

Few investors accumulate a significant amount of retirement wealth because postponing

consumption in favor of retirement savings is difficult for investors of all ages.
This is why the average person reaches the age of 55 or 60, only to realize that it's far
too late to begin saving for retirement if the goal in mind is to accumulate a significant
retirement nest egg. Studies show that from 45-54 years of age a person enjoys his or her
prime earnings capacity. A couple of years ago, Merrill Lynch did a study showing that the
median amount of financial assets for American men and women 45- 54 years old was
$1,500. That's right, $1,500 in stocks, bonds, cash, and CDs. Students never believe this.
They might not have $1,500 in a money market fund right, but they can easily imagine it.
Unfortunately, an imaginary $1,500 isn't the same thing.
The first ironclad rule of personal finance is very simple: Empty your checkbook by the
end of the month. No matter what income level, every person in America knows that you
must empty your checkbook by the end of the month. If you make $2,000, or $10,000 or
$100,000 per month, you must empty the checkbook by the end of the month. If you don't,
your spouse will assume that task and make sure that it does get emptied.
Each students plan will differ.