Your IRA & Wall Street

When investing your IRA, 401(k), etc…retirement funds in the “traditional” way such as stocks, bonds or financial “market” products, you incur on several costs such as: 3% to get in (broker’s commission) plus around 2% per year in miscellaneous fees, some of them already built-in the financial product you are buying. These built-in charges/fees are not disclosed.

It is not easy to make money in the financial market. Below you will see why. If you are a very experienced and professional day trader like my brother, who only started to make some decent money after 5 years of training and watching his stocks every day, then yes, you may have a chance of making money.

If you have insider information about a particular company or stock, yes, you may make some money. If you have a good “nose” about a particular company and you happen to be right, yes, you will make some money. For most of us however, this is not the case.

Let’s look at this simple example:

You have $100,000 in your IRA and this money is invested in traditional financial products tied up to the “market”. For the next two years, the market goes down 20% -this is actually conservative considering that the market has recently plummeted much more than this.

20% of $100,000 is $20,000, so by end of year one you now have $80,000. 20% of $80,000 is $16,000 so by end of year two you now have $64,000. Compared to your initial $100,000, you now have 36% less.

Many people are in this position today, they are trapped; now their only hope is to wait until the stocks rebound to regain their former value. If they sell then they would realize the loss. If they don’t sell, at least they have the same number of shares/stocks and therefore if the price of these shares comes back to its former value they would then recoup the losses. The more stocks fall, the more trapped they feel they are, since by selling they will lose even more.

Stock Analysts calmly answer not to worry, this is “normal”, the stock market always has rebounded over the last 100+ years and therefore one needs not to panic, one needs only to allow the “market” to return to “normal” since over the long run, the market has always appreciated. This is true, when you look at it over a 100 years period or over a very long term, below you will see why. If you are in your 40s right now and you lost a lot of value in the market, chances are there won’t be enough time between now and when you need the money to recoup your losses, below you will see why.

Let’s come back to our simple example:

$64,000 is now our starting capital at beginning of year three (same number of stocks, but less valuation). Say that year three is extraordinary and the market jumps 30%! 30% of $64,000 is $19,200, so this means that by end of year three we now have $83,200. Year four is also phenomenal and the “market” goes up by 20%!

This means that in these last two years, the market has recovered 50%!

Let’s recap, the market went down 20% on year one, 20% down on year two, 30% up on year three and 20% in year four. One may inadvertently then conclude that since it went down 40% and then up 50% one is then ahead 10%. This is not the case at all as the numbers below clearly demonstrate.

By end of year four our $83,200 went up 20%. 20% of $83,200 is $16,640; this means that by end of year 4 our total now stands at $99,840.

In other words, after a spectacular short recovery of 50%, we have lost $160 on paper.

On paper because it took us 4 years to lose $160.

According to the US Department of Labor, Bureau of Labor Statistics, who calculates the purchasing power of the dollar, today in 2009 you need $110,515 to have the same purchasing power of $100,000 as of 2005 -4 years ago (we are using a 4 year period of time in our example). They have an inflation calculator that you can use here: http://www.bls.gov/data/inflation_calculator.htm

These statistics are not really accurate since the government “massages” these numbers to look good for political reasons. The inflation rate or in other words, loss of purchasing power, is much more than reported, after reading the many ways they manipulate the numbers my personal opinion is that it is at least double of what they report.

For now, let’s assume they are right.

After a period of 4 years, you lost $160 + $10,515 a total of $10,675. However let’s not forget the “management fee” of 2%.

The effect of this 2% fee is much more than what you may think. Below you will see a more accurate approximation of this simple example once we incorporate this 2% fee:

Once we factor the fee, our losses are as follows:

$8,107 to get to our initial $100,000. ($100,000 – $91,893)
$10,515 of purchasing power, lost during 4 years.

Total Loss: $18,622

Had you put the money under your mattress you would have made more!

Does this mean that stocks are bad, no. This is not about stock bashing, however I hope that the preceding example clearly indicates that while some people may make money in the market (such as my brother) a great segment of people who choose this method of savings will have difficulty in maintaining their purchasing power through the years and they are at great risk of their hard earned savings being vaporized by market fluctuations which even when the market considerably rebounds, a lot of people may still not even recoup their original investment.

What about gains? Isn’t it the reason you give your money to someone else and you go to the trouble of investing in a complicated tax-deferred vehicle to make a gain? More money?

Fortunately this is not a route you have to choose unless you decide to do so. Investing this way, as explained above, is just one of the many and several options that you have.

Publicity, advertisements, TV shows and the like paint the picture that this is the only way to invest your retirement funds, nothing could be further from the truth. For an explanation of the many alternatives and ways to profitably invest your retirement funds while remaining in control, read the companion article “Use Your IRA” located at http://www.pfgcorporation.com/articles/use-ira.pdf.