Wednesday, December 3, 2008

How to Build Wealth in a Recession

Okay, it's now been officially announced that we're in a recession. Which you probably had noticed since the recession actually began in December 2007. Now that we're experiencing the volatile side of stock market volatility and 401(k) accounts are becoming 201(k)s, building wealth seems ever more difficult. It is, but there's a time honored way to increase your net worth that has almost been forgotten in America.

It's called saving. And it's the key to building wealth, in good times and bad. Here's why. Take the long term historical average gains in stocks, beginning around the early 1900s, and you'll get a figure like 6% to 7% per year. Let's work with 7%. Take out 3% for inflation, which is another rough long term average. That leaves 4%. Then, take out 1.5% for investment costs (read your mutual fund prospectuses; many of you will find this is no exaggeration). Then take out another 1.5% for taxes (remember that for 401(k)s and other retirement accounts, you'll pay ordinary income tax rates on your withdrawals, not the lower capital gains rates). We're down to 1% per year. If your investment costs and/or tax bracket are on the high side, you may be close to 0%. The numbers shown in your account statements may not seem so bad, but they aren't adjusted for inflation or reduced by the taxes you'll pay.

The picture gets grimmer when one factors in stock market volatility. The 7% per year average gain is just an average. As we so painfully know from this year, not all years are average and we're not in Lake Wobegon. The stock market first reached current levels (8419 for the Dow Jones Industrial Average) in February 1998. In other words, if you invested $1,000 in the stock market in early 1998 and held it until now, over ten years, your investment would have gone exactly, precisely nowhere. Passbook savings would have been more rewarding (plus you'd have a toaster and FDIC insurance). If your retirement strategy was to bank on stock market returns, you'd be looking at golden years eating dog food while working part-time at a discount store where you might be trampled by irrationally exuberant shoppers.

Simply stated, the key to building wealth is to save a lot. You won't net much from the stock market (and bonds and money markets are even less promising on a long term basis). Don't expect to be able to invest your way to millionaire status. We've seen what happens to those that buy into Wall Street's innovative financial engineering. And, unless you're a tremendously energetic self-starter with a very understanding family, you won't be able to become a millionaire by establishing a business.

In a sense, this is very reassuring. Saving is something anyone can do. You don't need a college degree, or even a high school diploma. You don't need a sophisticated understanding of investments or finance. Putting 10% of your earnings into passbook savings would probably do you more good than putting 1% of your earnings into stocks. While stocks, based on long term historical data, have been better performers than safer investments like passbook savings accounts, you should save in whatever way that gives you peace of mind. If you can't stomach stock market volatility, try the neighborhood bank. The worst thing you can do is give up and not save.

One advantage of saving a lot is you learn to live on less, because more of your current income is going into savings. As a result, you'll need less money in retirement to maintain your current lifestyle, while you'll put away more money. This saving-spending dynamic provides a powerful retirement planning tool. A little math reveals that saving 15% to 20% of your earnings for 30 years will, together with Social Security, pretty much allow you in your golden years to maintain your pre-retirement lifestyle. (See While saving that much is a challenge, it's not impossible. Try to rationalize living without Carzilla or a gargantuan flatscreen TV today so that you can avoid eating dog food in old age. Some of us don't find that a hard choice.

Those that are unemployed, retired, or face large medical expenses can't follow this strategy. But with unemployment around 7% (the currently announced rate is 6.5% but it's headed upward), that means 93% of the work force is employed and most of them can save. You may have a lot of excuses for not saving, but you can't buy a steak in retirement with an excuse. You'll need money for that. In the marathon that is life, slow, plodding, frugal savers win in the long run.

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