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Software Vault: The Gold Collection
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Software Vault - The Gold Collection (American Databankers) (1993).ISO
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STRATEGY.TXT
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1992-11-22
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6KB
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%%30,62,3%%
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 comfortably 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 CAPTOOL Global, 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, Dial/Data, 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 performance
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.