Discipline

Acropolis Investment Management, LLC

Acropolis is a St. Louis-based, fee-only wealth management firm. We serve individual investors, institutional investors and 401k plan sponsors. We specialize in retirement planning together with 401k and IRA rollovers.

To learn more about our financial planning services, please contact us at 1-888-882-0072.

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Daily Insight: Money & Happiness

Any sensible person knows that you have to save money for the future.

 

At the very least, you need to have money set aside for the so-called ‘rainy-day.’  If you don’t have a cushion, the consequence of a negative surprise can be a lot worse than if you have an emergency fund set aside. 

Read more: Daily Insight: Money & Happiness

Daily Insight: Get Rich Quick

On Friday, the Wall Street Journal ran a story about a company with no assets, no revenue and only one employee that has a market value of more than $6 billion!

 

I immediately had three thoughts. 

 

First, I was reminded of a story that I read in 2000 (I found it online here) during the technology bubble.  One of my favorite authors, Michael Lewis, wrote a column about NetJ.com that had no business operations but was worth $22.9 million simply because it had .com in the name.  How times have changed – this company doesn’t have .com in it’s name and is worth $6 billion!

 

Second, I thought I should forward the article to some of my colleagues that think the market is perfectly efficient.  I have pretty plainly said that I think the market is efficient, say 75 on a scale of 1-100 where zero is pandemonium and 100 is perfect efficiency.  For the people who say 95-100, explaining how the market puts a $6 billion value on nothing is going to be a tough job (although I suspect it won’t be worth this for too much longer).

 

Third, I assume that this is some kind of penny stock scam.  The stock apparently didn’t trade much in June, then jumped to $2.25 per share from 6 cents about a month ago and began a rocket ride higher to close at $13.90 on Friday.  According to data on Morningstar’s website, it had traded as high as $21.95 on Thursday.

 

There is no news yet that this is a scam, but it’s not uncommon in the wild and woolly world of penny stock scams.  In a classic ‘pump and dump’ scam, a scoundrel buys shares of a penny stock like this for 0.06 per share. 

 

He then hires scores of ‘boiler room’ brokers to sell the stock to an unsuspecting public and since there is no liquidity in the stock, the new activity pumps the price higher and the miscreant then dumps the stock for a huge profit. 

 

Years ago, I worked with a guy who had been with a firm like this and he said the movie Boiler Room with Ben Affleck and Giovanni Ribissi is a pretty realistic depiction of the lifestyle.

 

When you go to the Securities and Exchange Commission’s (SEC) website, there is actually a warning about this, but it’s a little troubling for me because the headline reads: Microcap Fraud.

 

Since nearly all of our clients have microcap stocks in their portfolio, I want to say explicitly that the microcap fund that we use doesn’t invest in penny stocks.

 

The fund that we use buys companies that are listed on the New York Stock Exchange, the Nasdaq Global Market and other reputable exchanges.  Those exchanges have requirements including market values, income and asset levels, share prices and shareholders.

 

Penny stocks, like the one listed in the Wall Street Journal article, generally don’t meet these requirements and therefore trade in the over-the-counter (OTC) market or bulletin board (OTCBB) market (often called the pink sheets), where there are nearly no requirements for listing.

 

Furthermore, unlike the poor soul who falls for a pump and dump scheme hoping to get rich quick and buys a penny stock, the fund we use is highly diversified.  It has more than 1,800 stocks, the largest stock is 0.57 percent of the fund and the top ten holdings only represent 3.91 percent of the fund. 

 

And while the companies are small, they’re often good-sized businesses.  The average market capitalization is $785 million and some of the larger holdings include brand name businesses as Papa John’s Pizza, WD-40 and Revlon. 

 

It should be no surprise that we won’t touch penny stocks, so if you happen to go to the SEC website, don’t let that headline give you any heartburn!

Daily Insight: When Rates Rise

Over the past five to seven years, interest rates repeatedly fell to record lows.  Nearly every time a record was made, it was broken again as rates continued to fall.

 

Last year, interest rates actually rose enough that the Barclays Aggregate bond index – the bond equivalent of the S&P 500 – lost money, -2.02 percent, for the third year since the index was created in 1976.  The first time was in 1994 when the index lost -2.92 percent, the second time was in 1999 when bonds dropped by -0.82 percent.

Read more: Daily Insight: When Rates Rise

July 2014 Portfolio Insights

The newest issue of Portfolio Insights is now available.  Please click this link to read.

 

Daily Insight: Fire Burn and Cauldron Bubble

 

I had intended for the subject line to be Bubble, Bubble, Toil and Trouble, but I don’t know Shakespeare very well: it’s ‘double, double, toil and trouble, fire burn and caldron bubble!’  Since I wanted to write about bubbles, I went with the latter half of the statement, which still sounds fairly ominous.

 

The New York Times has a terrific new section, The Upshot, that featured an article yesterday titled, ‘Welcome to the Everything Boom (or Bubble?) that included a long list of antidotes about rising asset prices including Spanish government bonds, New York city real estate, Iowa farmland and, of course, US stock prices.

Read more: Daily Insight: Fire Burn and Cauldron Bubble

Daily Insight: Jobs Jamboree Does't Disappoint

 

The fireworks started a day early on Thursday with the Bureau of Labor Statistics announcement that employment increased by 288,000 in June and that the April and May numbers were revised upward by a combined 29,000 jobs. 

 

June marked the fifth month where more than 200,000 jobs were added per month and averaged more than 250,000, a streak that we haven’t seen since the late 1990s.

Read more: Daily Insight: Jobs Jamboree Does't Disappoint

Mid-Year Equity Outlook

In this column of our January 2014 issue of Portfolio Insights, we said that stock investors ought to be winners in 2014 if short-term rates stay low and earnings hold up.  Sure enough, these factors have helped the S&P 500 return 7.13% this year despite negative geopolitical and economic headlines.

 

Given that the S&P 500 has now record six consecutive quarterly gains and volatility is near historical lows, we shouldn’t be surprised to see some ups and downs in the second half of 2014.  Still, we maintain our positive stance for equity markets this year as long as short-term rates remain unchanged and earnings achieve even some modest growth.

 

Beyond this year, the Federal Reserve has made it pretty clear that –although they can’t guarantee it – they would like to raise short-term rates in 2015.  That means earnings growth will be even more critical to justifying the market’s current valuations. 

 

(Higher short-term rates have many implications for capital markets and the broader economy, but let’s focus strictly on their impact on stock market valuation...The current price of a stock is the present value of future cash flows, simple math tells us that higher interest rates lower the present value of future earnings and, thus, lowers the current price of the stock.)

 

It’s important to understand that not all earnings growth is the same.  There are three primary ways that companies grow their earnings:

 

Organic sales growth.  Growing sales organically, which is simply selling more goods or services, provides the best type of earnings growth. Theoretically, the potential for organic sales growth is unlimited – there is no maximum limit on the number of sodas Coca-Cola sells or hamburgers McDonald’s serves. 

 

That said, organic sales growth is difficult to find in today’s environment of weak employment and below average economic growth.  We expect sales growth to remain uneven in the near term.  Longer-term, sales growth would benefit from higher business capital expenditures, labor market improvement and rising wages.

 

Margin expansion.   The next best type of earnings growth comes through margin expansion.  Margin expansion can occur for a myriad of reasons such as economies of scale, cost cutting, pricing power, etc.  Although margin expansion is a good way to grow earnings for a period of time, businesses can only improve margins so much. 

This is the case today in the US where companies are said to be operating at “peak margins” after cutting costs to the bone and boosting productivity during the Financial Crisis.  As a result, future earnings growth can’t rely on further margin expansion. 

 

Balance sheet leverage.  This is the least valuable way to create earnings growth and, unfortunately, is more prevalent recently since top-line sales growth is hard to come by.   

 

Examples in the current environment include borrowing at today’s historically low interest rates to repurchase shares or make acquisitions that can be manipulated to show earnings growth.  This is an unsustainable method of growing earnings and can actually be harmful to shareholder value in some cases.

 

Let’s recap: Margin expansion is an unlikely source of earnings growth for the next few years.  Organic sales growth is preferred, but difficult to come by in the near term.  The easiest, but least sustainable, method of earnings growth today is through share buybacks or acquisitions. 

 

Equity prices today are rising more rapidly than earnings, which results in more expensive valuations. Valuation, the price you pay for earnings or book value of a company, is one of the best predictors of long-term equity returns.  The implication of higher valuations is lower expected long-term returns. 

 

(Note that I say long-term.  Short-term returns tend to ignore valuations and history has shown us that markets can remain overvalued for long periods of time.)

 

Using the P/E ratio suggests the market is overvalued, but we still expect investors to be compensated for the risk they take by having equity exposure. The reward to long-term investors holding equities is more attractive than the return on bonds.  Equity exposure should also help mitigate the loss of purchasing power, which is a particularly important feature given that global central banks are hell-bent on increasing inflation.

 

The key to successful investing in this environment is to keep expectations in check and maintain discipline during periods of volatility. 

 

Read more: Mid-Year Equity Outlook

Financial Times Includes Acropolis in the Top 300 RIAs

Acropolis was named a top Registered Investment Advisor (RIA) firm by the Financial Times!

 

A subscription may be required, but here is the link to the report.  

 

When we started out nearly 12 years ago (our anniversary is in August), we received a few accolades from a magazine published by Bloomberg that consistently said that we were one of the fastest growing firms.

 

Still, compared to other firms on the list, we were pretty small back then.  We just crossed $1.1 billion which, by my estimate ranks us between 100-125 among RIAs that serve clients in the same way that we do (but not as well, of course).  There are other firms like hedge funds that register as RIAs, but obviously don't do the same thing.

 

In the FT survey, they said that the size of the firm accounted for about 85 percent of the ranking, arguing that 'size is a key indicator of quality, in that bad firms rarely continue to attract and retain clients.'

 

While that's true to some degree, I have seen some large firms that may have said all of the right things at the top only to fall short when it comes to consistent implementation.  And as one of the founders of Acropolis, I can say that it's a lot more challenging to deliver consistently high quality advice and service.

 

Thankfully, we have a large team of dedicated, well trained people who really care about our clients and doing the right thing.  There is still work to be done (and there always will be), but we are far more organized than we were a decade ago and we're adamant about not sacrificing quality for growth.  

 

A number of clients over the years have said that they didn't know that we've grown as much as we have, which is a real compliment since it means that their experience as a client is unchanged from the early days.

 

In addition to the firm size, the FT considered five other factors including firm growth, length of operation, SEC compliance record, professional designations held and the quality of the website.  

 

Of course, we are very proud and gratified to be included on the 'elite' list of advisors by the FT.  It should go without saying that we are deeply appreciative to our clients for making this possible.  

 

On behalf of everyone at Acropolis - Thank you!

The Power of Compounding

“Compound interest is the eighth wonder of the world.  He who understandings it, earns it…he who doesn’t, pays it.”  - Albert Einstein

 

The most important rule in planning for retirement is: save early and regularly.

 

Saving early is important because of the power of compounding, which has a snowball effect on your money.  As a snowball rolls along, it gets bigger with each rotation and, thus, collects even more snow with each following rotation, resulting exponential growth in size.  Similarly with your investments, interest that is reinvested generates even more interest, which makes your total investment grow even larger. 

 

Let’s look at a simple example of a $10,000 lump-sum investment that earns 6% each year.  (Click here for the expanded 30-year table.)

 

Year

Value

6% Interest

Interest Earnings Increase from Prior Year

1

$10,000

$600

-

2

$10,600

$636

$36

3

$11,236

$674

$38

4

$11,910

$715

$40

5

$12,625

$757

$43

6

$13,382

$803

$45

 

Even though the interest rate remains unchanged at 6%, the amount of interest income increases every year.  Just as a snowball accumulates more snow with each rotation as it increases in size, your investment generates a greater amount of interest as the interest rate is applied to a larger amount each year.

 

Over time the interest earned surpasses that of the initial investment, which you can see graphically below.  

 

2014-06-13 Power of Compounding.V2

 

If you withdraw the interest earnings each year rather than reinvesting them, then you receive $18,000 in interest payments over 30 years ($600 per year).  However, by reinvesting the interest each year in our example, you generate a total of $47,435 in interest earnings over those 30 years – an additional $29,435 in interest on top of the $18,000 generated by the initial investment.

 

Now that we understand the math of compounding, let’s apply it to investing…Consider two friends named Bert and Ernie that start investing at different times. 

 

Bert starts investing today by making a $100 contribution each month to his retirement account.  After ten years of these monthly investments, Bert needs the $100 to help make the mortgage payment on a new home.  He doesn’t make any further contributions to the account and doesn’t touch the balance until he retires 30 years later.

 

Ernie waits to invest later since retirement seems so far away.  Ten years from now, he begins investing $100 every month until he retires 30 years later.

 

Click here for the full spreadsheets used for this example.

Bert

Vs.

Ernie

$100

Monthly Contribution Years 1-10

$0

$0

Monthly Contribution Years 11-40

$100

10 Years

# of Contribution Years

30 Years

$12,000

Total Contributions

$36,000

8%

Hypothetical Growth Rate

8%

$200,064

Value After 40 Year Period

$149,036

 

As you can see in the summary table above, Bert comes out ahead despite contributing less money to his account for fewer years than Ernie

 

The secret behind Bert’s success is compounding and time.  As time horizon increases, so does the effect of compounding.  Even though Bert made a smaller total contribution, his investment had more time to benefit from the effects of compounding.

 

It’s easy to procrastinate with savings, particularly for long-term goals such as retirement, but the power of compounding should convince you to do otherwise. 

 

Thanks for reading,

 

Peter Lazaroff, CFA, CFP®

St. Louis, MO

Acropolis Investment Management

 

Daily Insight: How to Get Better After-Tax Returns

One of the questions that we get from time to time is why one spouses account is outperforming the other.  It’s kind of a funny question because it reveals some sort of mild competition between a husband and wife, who are presumably on the same team.

 

When there is a discrepancy, it almost always has to do with what type of investment we put in certain accounts.

 

For example, imagine a lovely couple named Sid and Nancy.  Sid is retired and his investible net worth of $500,000 is an IRA that was transferred from a 401k plan.  Nancy’s employer didn’t have a 401k plan, so all of her $500,000 savings is in a revocable trust.    

 

Let’s assume that we recommended a 50/50 stock/bond portfolio and to keep it simple, let’s say we used an S&P 500 index fund for the stocks and a Barclays Aggregate bond index fund for the bond allocation.

 

We don’t know what other advisors are doing, but we think it would be pretty common for the advisor to put the 50/50 mix that we advised in each account.  One year later, both accounts would have enjoyed the same performance.

 

Acropolis does it a little differently.  First, we assume that Sid and Nancy are a team. 

 

Second, we want to maximize the after tax returns for the couple, which means using what’s called an ‘asset location’ strategy that means investing the entire stock allocation in the trust (or taxable account, as we call it), and the entire bond allocation in the IRA (or tax-deferred account).

 

Let’s look at what would have happened over the past five years if we had invested each account identically and if we had pursued the asset location strategy.

 

2014-06-12 Asset Location

 

I used two actual index funds and got the pre- and post-tax return data from Morningstar.  It assumes the highest Federal tax rate and no State taxes, so it isn’t perfect, but it gets the idea across.

 

In the top section, notice that bonds are far less tax-efficient than stocks – almost 25 percent of the return is lost to taxes.  That makes sense because most of the return from bonds comes from interest income, which is taxed as ordinary income, like wages and salary. 

 

Stocks earn most of their return from appreciation and an index fund is tax-efficient because there isn’t much turnover.  So, there are some capital gains taxes and some taxes from dividends, which are preferably taxed compared to interest income (the rate varies now depending on your income, but it’s still better).

 

In the second table, we can see that the pre-tax return of a 50/50 stock/bond portfolio over this period (and what a period it was!) was 11.55 percent.  If we has invested the money identically between the two accounts, we can see that we would have lost 0.80 percent to taxes and our after-tax return would have been 10.75 percent.

 

Now, using the asset location strategy that we use, the pre-tax return is the same at 11.55 percent, but the after-tax return is much higher and the tax cost is much lower.  That’s because we would have earned 17.9 percent on the stocks in the taxable account and earned 4.78 percent on the bond portfolio in the IRA.

 

Obviously, you want to maximize the after-tax returns and using the asset location strategy yielded an additional 0.59 percent per year in this case.  Obviously, the pre-tax returns won’t always be this good, but the tax costs should be roughly constant, which means that this strategy is even more critical in a lower return environment.

 

The only downside is that the two accounts don’t grow at the same pace – the taxable account holding stocks should grow more over time and is a lot more volatile.  The tax-deferred account that holds all bonds grows much more slowly and at a steady pace.  It can lose money, for sure, but not like the account holding stocks.

 

If you don’t have a global view of your accounts, then it can be disconcerting to see one account change a lot more than the other.  The key, though, is to remember that all of your accounts in most circumstances represent all of your assets and what you want is to maximize the after tax return for the whole pie.

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