Simtel MSDOS 1992 June/SIMTEL_0692.cdr/msdos/menu/rnr3d.arc/STRATEGY.TXT

Text File | 1988-10-08 | 5.6 KB | 116 lines

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 Managing Return On Investment - A Strategy


 Return on investment compounded by time equals wealth.

 Consider an Individual Retirement Account (IRA) in the implementation of
 this concept.  An annual $2000 investment earning an 8% return will
 build a $518,000 nest egg over a forty year period.  The same annual
 investment, earning 12% will produce nearly triple that amount,
 $1,534,000, over the same period.

                              Value ($ thousands)
    Yrs   Amount     2%   4%   6%   8%  10%  12%  14%  16%
  ┌─────┬─────────┬────────────────────────────────────────┐
  │     │ $20,000 │                                        │
  │ 20  │    +    │  79  103  138  185  249  337  457  620 │
  │     │ $2000/yr│                                        │
  ├─────┼─────────┼────────────────────────────────────────┤
  │     │ $20,000 │                                        │
  │ 30  │    +    │ 117  177  273  428  668 1081 1732 2777 │
  │     │ $2000/yr│                                        │
  ├─────┼─────────┼────────────────────────────────────────┤
  │     │         │                                        │
  │ 40  │ $2000/yr│ 121  190  310  518  885 1534 2684 4720 │
  │     │         │                                        │
  └─────┴─────────┴────────────────────────────────────────┘

 If one does not live ostentatiously, this difference may not seem
 important, as half a million dollars seems quite sufficient for
 retirement.  Until one considers inflation.  Adjusted downward to
 today's dollars, assuming 6% inflation, one's purchasing power would be
 reduced to  $121,000 (8%-6%=2%) and $310,000 (12%-6%=6%), respectively.
 The importance of achieving the higher rate of return now becomes quite
 clear!

 But how can an individual monitor his rate of return and thereby
 hopefully control its direction?  One approach would be to invest solely
 in low-risk original issue fixed income instruments (e.g. bonds, CD's,
 and Treasury notes) with the intent to hold to maturity.  One could then
 determine the approximate rate of return at any one time by computing a
 dollar weighted average of the coupon rates of all securities held.
 However this approach would be self-defeating because the rates of
 return one would inevitably receive would not exceed inflation by much
 over the long term.

 The higher return on investment needed to retire confortably generally
 requires investment in equities and/or investment in fixed income
 instruments timed to take advantage of interest rate swings.  This can
 be done directly or through mutual funds.  However, since such
 investments do not have fixed rates of returns nor guaranteed redemption
 values, determining and tracking one's rate of return becomes important,
 yet is also more difficult.

 In the case of mutual funds, one might try to rely upon the return
 rates stated by the fund managers or reported by tracking services.
 These rates, however, are for a specified time period, and generally
 will not represent the rates one has actually achieved.  This is due to
 the differences in timing and amount of an investor's actual remittances
 and redemptions versus that assumed for the fund's reported rate.





_




 The resolution to the timing issue is to compute return on investment
 (ROI) using the internal rate of return method.  This calculational
 technique takes into account both the timing and dollar weighting of
 cash flows into and out of a portfolio as well as initial and ending
 portfolio values.

 Because internal rate of return must be computed using iterative
 calculational method, for all practical purposes it must be calculated
 by computer.  Techserve, Inc.'s family of portfolio managers, PFROI,
 CAPTOOL, and PFPRO, compute IRR-ROI as well as perform many other
 portfolio management functions (e.g. income reporting, capital gains
 reporting with three tax lot methods, portfolio tax planning, portfolio
 reports and price downloading from Dow Jones, Compuserve, Warner, GEnie,
 etc).

 A typical strategy for an investor using PFROI or CAPTOOL would be to
 set a target rate of return pegged to an index such as the S&P 500 index
 or the consumer price index.  For example, he may wish to exceed the S&P
 500 index by 3% (because dividends not included in S&P 500), but also at
 a minimum exceed the CPI by at least 8% over the long run.  Since PFROI
 and CAPTOOL can both track up to three indices at a time, the user would
 record the value of these indices each time a portfolio valuation is
 recorded and stored.

 The investor then would have PFROI or CAPTOOL generate perform- ance
 reports to see how the portfolio has performed versus these indices over
 both the long and short run.  Lagging performance versus the S&P 500
 would indicate that the investor is being too conservative in investment
 selections and should re-evaluate his holdings.  Failure to stay ahead
 of the CPI growth rate by the target margin would indicate a need to
 rebalance the portfolio in favor of more inflation-proof holdings (e.g.
 real estate, REIT's).

 Upon nearing retirement, an investor would then typically reduce his
 targeted return and re-deploy his assets accordingly in favor of safety.
 Investors who have successfully pursued their strategy, however, may
 find themselves with excess funds which they can commit to a separate
 aggressive portfolio in pursuit of additional growth in wealth during
 retirement.