Compound interest

The effect of compound interest on $100 is explosive

The following questions were generated in response to my recent article describing how to turn $3,000 (or $365 per year) into $50 million.

Q. I’m thrilled to read your plan to turn $365 a year into $50 million for a newborn baby. I have a new granddaughter, and all I can save is $100 a year. Where can I invest this amount in a small cap value fund?

A. For starters, I assume you know that you won’t get the same result from $100 per year as you would from $365 per year. But the results over a lifetime can still be impressive. You can invest any amount, no matter how small, in any of the over 100 commission-free ETFs offered by TD Ameritrade.

These include two good small-cap candidates: iShares S&P Small-Cap 600 Value IJS,
-2.41%
and iShares Russell 2000 Value IWN,
-2.35%.
I would choose IWN because of its lower price to book ratio.

For investors with $1,000 or more to start with, my pick would be the SPDR S&P 600 small-cap-value ETF SLYV,
-2.41%,
available commission-free from Schwab. I like it for its relatively low expenses, small average company size, and low price-to-book ratio.

Q What do you think of the Guggenheim S&P SmallCap 600 Pure Value (RZV) ETF? He holds smaller companies at a significantly lower price-to-book ratio. Is it worth considering despite its higher expenses?

A. In a word, yes. The Guggenheim ETF RZV,
-2.79%
is available commission-free from Schwab, although it is not on their shortlist. I think this ETF will be a long-term winner. Its average holding is 40% lower than other small cap ETFs and the price-to-book ratio is around 30% lower.

But there is a major downside: extreme volatility. According to Morningstar, RZV was among the worst performers for small caps in 2007, 2008 and 2011 (bad years for this asset class). On the other hand, it was number 1 in the very good years of 2009 and 2013.

If you want to invest in RZV, I suggest you consider splitting your investment between RZV and SLYV.

Q If I give my grandson a $50 million gift, don’t you think his parents will be envious and resentful unless I do the same for them?

A. If you actually gave your grandson $50 million and his parents nothing, they would have good reason to be upset.

But if you follow my suggestion, you’re not giving anyone $50 million. You give your grandson $3,000 with the theoretical possibility of eventually turning it into $50 million.

Of that $50 million (if it ever reaches that amount), $49,997,000 will not come from you. It will be the result of the investments you (and possibly your grandson) make with that money.

Even if everything goes as you hope, it won’t be like winning the lottery. By the time your donation even hits $5 million, your grandson will likely be well into his 60s.

If you’re worried about his parents’ reaction, you can give them an equal amount and let them do whatever they want with $3,000.

Q I worry that if I set up my granddaughter with a $50 million plan, she might become lazy or complacent while expecting a large inheritance. How can I prevent this from happening?

A. Ultimately, you cannot control the attitudes or behavior of your heirs. However, as you can see from my answer to the previous question, your granddaughter is unlikely to have a ton of money for very long.

In fact, with a 12% return, at age 65 his IRA should be worth about $668,000 in 2015 dollars.

Perhaps the most important message you can convey is the intent behind your contribution. The best way to do this is to have a conversation with her when she’s old enough to understand.

Q How about adding value from international small caps and emerging markets to the portfolio?

A. It is possible that greater diversification will improve returns, but there is no guarantee. Over the past 15 years, US and international small caps have each compounded at 11.1%, and emerging market small caps at 12.1%. (Over the same period, the Standard & Poor’s 500 index rose about 5%.)

Q My children are 4 and 6 years old. I like your plan, but how much do I have to put in now to get it to $50 million?

A. If you accept the assumption that each of your children will let the money accumulate at 12% until age 65 and then start withdrawing 5% of the balance each year until age 95, you will find the answers to your question in a large array of values which is available on my website.

In your case, you should invest $4,721 now for your 4-year-old and $5,921 now for your 6-year-old.

QHow can I prevent my child from cashing out the account?

A. This question is more about your relationship with your child than the investment.

During your lifetime, you may neglect to tell your child about the account. But that would deprive you of the excellent teaching and learning opportunities that come with this plan.

After you die, the only safe way to keep the money away from your child is to set up a Crummy Trust with strict rules. This would be expensive and would require a variable annuity instead of the much more tax efficient Roth IRA.

Q If I give this money to my grandson, will it reduce what he receives in college financial aid?

A. It could.

Normally, financial aid officials at college will consider your grandson’s assets to be money he can afford to contribute towards the cost of his education. They will likely take a similar attitude towards a certain percentage of the assets held by your grandson’s parents.

But if the money is registered in your name, then it belongs to you and will likely be invisible to people determining financial aid. This is a good reason to consider a delay in transferring money into an IRA.

Q Where can I learn more about all this subject?

A. I recorded a podcast called How to Turn $3,000 into $50 Million. This presentation outlines all the steps parents and grandparents should consider to implement this amazing strategy.

Richard Buck contributed to this article.