The Millionares' Way

 

People seem to think a million dollars is the easy answer. It is a nice round number and a lot of money, but is it enough? I think so—maybe even too much.

Let's say you found a million tax-free dollars in the street today. Without a long discussion of risk versus return, and with the hope that it's understood that more of the latter requires more of the former, let's look at how different investment classes have performed over time. Since 1926, investments in a broad basket of the stocks of small companies have returned about 12.5% a year. Investments in large companies returned about 10.5%, long-term corporate bonds about 6% and long-term government bonds about 5%.

Whether or not history repeats itself exactly, it's tough to argue with the assumption that stocks will continue to produce the highest returns. That doesn't mean that you should follow the hordes of dipsticks who spent (and lost) their life savings on Iomega stock because the company made an adorable blue disk drive. But it does mean that there's reason to believe that balanced stock portfolios, particularly in the form of solid mutual funds or index funds, will continue to post impressive results. Now, I wouldn't recommend such an aggressive strategy to someone who is not on the retire-early warpath, but a free million's a free million, so suppose you divide your million thusly: 40% in an aggressive mutual fund (i.e. small company), 40% in a solid growth and income fund (i.e. large company), and 20% in the relatively safe environs of a corporate bond fund. Assuming past results repeat themselves, you're looking at a 10.6% annual return—respectable by any measure. That means that if you do nothing but sit on your booty, you'll have $106,000 a year to buy martinis—a darn nice salary considering you didn't have to lift a finger.

A smarter plan would be to add at least 3.1% of that 10.6% back to the principal, to cover the cost of inflation (averaging about 3.1% since 1926). That leaves you with $75,000 in today's money year after year, rather than letting inflation erode the value of your 10.6%. I'd also shave an additional 2% ($20,000) off the first few years to cover the inevitable down years. Remember, the sweet returns of the stock market are averages—that means not only will certain years return less than 10% but some years will return nothing at all and still others will be losing ones. If your million is first invested during a bear market, you'll have to be extra frugal until the market rebounds.



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