The cost of borrowing from your tax deferred account

Overview
If you have a sizeable balance in your tax deferred 401, 403, IRA, Keogh, or other tax free account, it can be tempting to borrow against the account for hardship, medical, education, or the purchase of a home. There are times when a loan makes good financial sense. However, most of the time it is best to leave your funds in the account to take advantage of the tax free compounding (click here to read a previous series that covers compounding in detail). This article will go over the “cost” involved with borrowing against one of these accounts.

Revisiting the effect of compounding
If you read the previous series on compounding interest, you understand the enormous benefit compounding brings to multiplying your final account balance after many years. Most advisors recommend you invest in a combination of stocks and bonds to spread the risk and still participate in the higher historical return stocks provide.

Costs of borrowing funds
When you borrow from your account, the borrowed funds are usually paid back at the lowest rate – usually the bond rate (approximately 4%). In that case, you lose out on the significant long term gains that would have been achieved from a higher compounding rate closer to the historical stock gains of 8%. However, another “penalty” that many people are not aware of is that funds used to pay back the loan are after tax money. You can’t deduct the money used to pay off the loan. Therefore, you are using money that has already been taxed to pay back the loan. The money you paid in taxes could have also benefited from compounding interest over time. So, you lose two ways – the higher compounding the funds could have received if left in the account and the compounding of the taxed dollars spent to pay back the loan. There is also the potential for a third penalty if the borrower decides to lower the ongoing regular investment into the account in order to afford the new loan payments. In this case, there is additional loss of compounding growth against the reduced contributions over time. Lets look at an example to help illustrate the issues involved with borrowing.

Simplified example of borrowing from a tax deferred account
Assumptions: 1) Joe has $75,000 in his account earning a long term average annual return of 6% and is contributing $1,000 monthly; 2) He borrows $25,000 (for whatever reason) from his tax deferred account; 3) The current bond rate is 4% and that the loan will be paid back over 15 years at this 4% rate with a monthly payment of $184.92; 4) Joe pays a combined State and Federal tax of 30%.

Had Joe had continued his investment plan of $1,000 monthly and not taken out a loan, he would have a ending balance of $474,876 in 15 years. By removing $25,000 as a loan, the remaining $50,000 balance with the $1,000 monthly contributions would grow to $413,523 after 15 years or $61,353 less ($474,876 - $413,523). However, the $25,000 would add back a 4% compounding return into the account over the 15 years of $8,286 as the loan is paid back. This lessens the difference to $53,027 ($61,353 - $8,286).

Adding real life complexity to the example
That was a very simplified example since the 4% loan payments would actually be added back into the same investment split that the new contributions are distributed across - bonds, stocks, etc. So, if the account is earning a 6% average return from the current investment split, then each payment would compound at this 6% rate through the remaining years. This would lessen the $53,027 difference. Another complexity is the 4% loan is paid back with after tax dollars. Since the combined tax rate is 30%, then it takes $1.30 of before tax funds for every $1.00 paid toward the loan. Since the monthly payment on the 4% $25,000 loan is $184.92, then approximately $55 is paid each month in taxes (185 dollars x 30 cents taxes on each dollar equates to $55 in taxes). If there was no loan, then this $55 could have been invested monthly into the tax deferred account at the average 6% rate to earn $15,995 after 15 years. This is an added loss on top of the $53,027 difference calculated earlier.

Summary
You need to see a qualified financial advisor to look at your particular situation. Information provided above are hypothetical and not meant to be financial advice for any specific situation. However, as you can see, there are many variables that could affect the calculations. But, in all cases you end up with less in your tax deferred account over the long term by borrowing funds that by not borrowing. Again, there are situations where loans may make sense, but you need to be aware of the long term consequences of missing out on compounding over time for the funds borrowed from the tax deferred account. A financial advisor is usually going to be much cheaper than the amount of money you may lose over time by borrowing.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8

INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13

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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/

Your feedback is wanted: Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision.

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Part 3: Understanding Inflation – The dollar to gold price relationship

Overview
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. The first article provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. Last week’s article discussed the importance of investing in assets that grow faster over time than the rate of inflation. This article will discuss the relationship between the value of the dollar and prices of high demand commodities such as gold during times of inflation.

Valuing the dollar
Normally the dollar is worth more or worth less based on the demand for U.S. goods, services, and assets/products. If foreign investors buy lots U.S. items such as real estate, treasury bonds, stocks, or other, then they must first convert their currency into dollars in order to pay for the purchase. When there are many foreign investors converting to dollars, then the demand for dollars is high and the value of the dollar rises. When demand is down, then the dollar is worth less.

A crude analogy to illustrated to change in value of the dollar
Assume there is a small town of 5,000 people in the middle to high income bracket that all live in apartments due to lack of available land for building homes. Then assume one home is finally built in the town and it is in very high demand. Would it be unreasonable for the asking price on the home to be at least 2 or 3 times as much as for a similar home in a large town that has plenty of housing? Could the price even go as high as 10 times as much or more? Well this is a crude example of how the value of the dollar also goes up when there are fewer dollars available to meet a rising demand by foreign investors wanting to purchase our treasuries, stocks, real estate, etc. Similarly, when there are many more dollars available than demand, then the value of the dollar declines – it is easy to find dollars to convert from their currency. In those times, foreign investors are not seeking to buy as many our things so there is less demand for dollars to convert with.

The current world-wide demand for dollars
With the world-wide financial crisis hitting most foreign countries harder than the U.S., investors in those countries want to buy U.S. issued securities such as treasuries that are backed by the full faith of the U.S. government. Since we have the largest economy in the world, foreign investors feel U.S. securities are the safest available, at least they perceive them more safe than investing in their own country. That is why the dollar has soared in value recently with so many foreign investors seeking these perceived safer investments that must be purchased with U.S. dollars.

Relating gold to the dollar to inflation
Currently, there is also a demand for gold since most investors around the world view it almost as a standard currency that is valued by everyone. That gives it a large base of investors that keep the price high, especially in times of high uncertainty such as the world is currently experiencing.

In terms of the dollar, you need to realize part of the price of gold rising can be attributed to times when the value of the dollar decreases. In those normal times, it is not so much that gold has risen in price, but that it takes more dollars to buy the same amount of gold. As an example, assume you can buy gold for $1,000 per oz. Later, the value of the dollar decreases by 10% to only be worth 90 cent when compared to what it was worth when purchasing $1,000 oz worth of gold. In this case, you would need to have $1,111 to buy the same oz of gold under the current lower valued dollar. This is derived by taking the $1,000 originally paid divided by 90cents for each lower value dollar meaning you will pay $1,111 using these lower value dollars for the same ounce of gold. So, it isn’t that gold has risen, but instead, gold has stayed the same and the value of each dollar to buy that gold has gone down. This is a time of inflation when the value of the dollar goes down, which is why prices paid for many things seem like they are going up

Relating gold to the dollar to deflation
This also works in the opposite. If over time the value of the dollar had instead increased by 10%, then each new dollar would be worth $1.10 of the older dollars. In that case, we take the original dollar paid $1,000 oz of gold and divide by the new $1.10 value dollar to only pay $909 per ounce of the same gold. In this case it looks like deflation since the price has decreased over time. This would also be true of many other items when the dollar increases in value as we are currently seeing.

Amplifying my point about the price of gold during inflation and deflation
An interesting observation I’ve made recently is in times of very high uncertainty, as we have around the world today, there is the added demand for gold that is also causing the price to increase on top of whatever the value of the dollar does. If the value of the dollar increases, as it has recently due to the high demand for our treasuries, gold has still increased due to high demand by investors around the world. So you can’t always only count on the straight mathematical price model I used above to calculate the price of gold during inflation and deflation.

Summary
Notice that many commodities follow a similar pattern during inflation and deflation where their prices move in the opposite direction of the value of the dollar, under normal market conditions. As the dollar rises, it takes less dollars to buy the same commodity like oil (affecting the price you pay per gallon for gas at the pump), silver, gold, etc. As dollars fall, it takes more dollars to buy the same items. Just a general rule to think about when investing – keep a close eye on the value of the dollar and world demand trends for the dollar (rising demand or decreasing demand).

Accredited sophisticated investors are very mindful of such trends before making investment decisions. Don’t let them take advantage of your fear when you sell or buy at the wrong time when they are doing the opposite. Continue educating yourself about the investments being considered and all factors that affect those investments.

I hope this article helps you to not just look at the price of gold or other commodities by itself. Consider the valuation of the dollar, world demand trends for both the dollar and the commodity being considered, etc. Look for patterns and relationships. Understand those well before moving forward. Be an educated investor and you will be way ahead of the ordinary investor who wants to “get in before it is too late” or “get out since it is going to crash”. Those are opportunistic times for the educated investor to do the opposite of the crowd.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8

INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://www.ino.com/info/128/CD3400/&dp=0&l=0&campaignid=13

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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/

Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Part 2: Understanding Inflation – choosing the right investments during inflation

Overview
This is a series of articles intended to help you understand how inflation can erode your long term investments and how you should counter those effects in your investment strategy. In last week’s article, I provided a definition of inflation and showed the effect it has on reducing the value of a dollar over time. This week I want to show the importance of investing in assets that grow faster over time than the rate of inflation. Sophisticated investors know they must increase the value of their portfolio at a higher rate than inflation in order to grow their wealth. Any growth rate lower than inflation (such as the interest rate paid on most savings accounts) would still erode the value of the investment portfolio over time. Lets look closer at this balance of growth against inflation.

Overcoming the effect of inflation
As stated above, there are two opposite forces that affect what your long term investment portfolio will end up accumulating: inflation and rate of growth. Any long term investment strategy must consider the effect of both and incorporate a plan for accumulating assets that will increase in value faster than the rate of inflation. To do this, many investors seek assets that have limited quantity such as rare high grade coins, rare art, gold, desirable real estate. Over time, the scarcity of the asset will make them harder to buy so the price usually goes up. In addition, accredited investors have access to other investments that have high risk of loss, but demand high rates of return such as participation in a private placement, special hedge/leveraged funds, providing seed capital for a new or young business/product/service, etc. These investments each carry different levels of risk and expected returns. All of these factors need to be incorporated into a long term investment strategy/plan.

You must have an investment strategy/plan
An investment strategy must have set investing rules and boundaries you will maintain no matter what. Consistently applying a strategy over time will take out emotional decisions that usually go against what needs to be done during times of uncertainty. Your strategy should incorporate your end goal, how long you plan to invest, and what you are going to invest in to get there. You can make improvements in your plan, but only change one thing at a time - don’t make another change until enough time has past to confirm if the change worked or should be reversed. Continuing this refinement process will go a long way toward getting you to your end goal and help refine your investing skills.

Research historical returns on your prospective investment
Keep in mind a general estimate of inflation is about 3% to 4% per year. You want to make sure your entire portfolio gets at least 4% over time just to keep up the same real overall value. Ideally, your return should consistently be higher than the historical rate of inflation to increase your buying power by the time you retire. Maximizing contributions into tax free accounts is one of the best ways to increase compounding of your long term investments by deferring taxes on the gains.

We are currently in a very scary down market. Seems like everything has dropped considerably including “blue chip” stocks, real estate, minerals such as oil and gas, etc. However, if this down turn is like so many others in the past, then these assets will again come into favor with increasing prices along historical averages. Research the historical average of assets you want to learn about investing in. Within those assets, learn what makes some more desirable than others (for example, different locations of real estate have dramatically different historical returns). Chose those assets that provide the historical returns you need to reach your goal as part of your strategy. Diversify enough to decrease the risk of loss to your portfolio, but not too much as to dilute any gains made by each asset. Periodically shift funds from one asset to another to rebalance your portfolio.

Putting it together
In a previous article on compounding interest, I showed how a $1,000 investment in a tax free compounding interest account after 40 years can provide an additional 122% return at 4% interest rate ($2,224 account total minus the $1,000 invested, then divide that difference of $1,224 by $1,000 to get 122%), 394% at 8% ($4,940 balance - $1,000, then divide by $1,000), and 5,759% at 16% ($576,923 balance - $1,000, then divide by $1,000).

In last week’s article, I showed how inflation does the opposite by reducing the buying power of $1,000 over 40 years to only $201 for a consistent 4% rate of inflation. This is a 80% reduction ($1,000 - $201, then divide by $1,000) in buying power. In other words, $201 is only 20% of the value the initial $1,000 after 40 years. In reverse, to maintain a $1,000 buying power after 40 years you would have needed to initially invest $5,000 the first year ($5,000 x 20% after 40 years leaves $1,000). Starting with five times the initial $1,000 investment defeats the purpose of keeping that initial $1,000 investment at the same buying power after 40 years. Therefore, we need to invest the $1,000 at a compounding rate that negates the devaluing rate from inflation. Since we need the initial $1,000 invested to act like $5,0000, we must invest at an annual rate that generates 400% return after 40 years ($5,000 - $1,000 invested means we need to generate the equivalent of $4,000 additional dollars in the beginning over the 40 years or 400%). From the previous paragraph, we need an annual tax free compounding interest rate of 8%. Interestingly enough, this is the historical growth rate you hear that the stock market has grown. That is why many financial advisors recommend investing in a stock index (S&P 5000) to keep up with inflation. Of course, these days that seems like bad advice with the significant drop stocks have taken in only a few months. But, if you believe history will repeat itself again, then you should still include stocks in your investment strategy to assure gains keep up with inflation. As mentioned earlier, there are many other investments that historically have met or beat the historical rate of inflation such as choice real estate, private placements,

Summary
A small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. Your investment strategy/plan must include investing in assets that increase with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.

Next article in this series
Next week's article covers the relationship between the price of gold and value of the dollar during times of inflation and deflation.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -

Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8

INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/

- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors. This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Part 1: Understanding Inflation and how it affects you

Overview
You hear a lot about inflation (rising prices) and deflation (decreasing prices) these days. Most people feel we are currently in a period of deflation, but worry that the huge stimulus plan and associated funds from the government will force the country into a period of very high inflation. What does this mean to you and how will it affect your investment strategy?

What is inflation?
In general, when prices of most things in the economy continue to rise over time, that is considered inflation (read what Wikipedia says about inflation). What this means over time is that the value of a single dollar will buy less now than it did at some time in the past. Small to moderate Inflation is usually good for an economy since companies usually pay higher wages (give employees raises periodically) which means more money to spend. Other people who are self employed can make more money every year by raising prices. As long as income continues to rise as inflation rises, then the economy is able to expand and people are still able to buy the things they need and want.

However, when inflation rises too fast, then wages/income may not be able to keep up. In that situation, people are not able to keep up with buying the same things they used to. The standard of living goes down and the economy gets out of balance. Something has to give. Usually the government steps in and raises interest rates to take money out of the economy in an attempt to bring high inflation down to the small to moderate level desired.

What does inflation mean to you?
Simply, it means that you can’t buy as much today as you could years ago with the same dollar. In my own case, I can remember as a kid paying 10c for a candy bar and paying 45c for a movie ticket. When candy went to 25c, I thought that was crazy and had a hard time paying that much in my mind. Now candy bars are well over $1 and movie tickets are around $10! I went from being able to go to the movie and get five candy bars (not that I EVER would have done such a terrible thing as a little sweet tooth boy…ha) to today spending nearly $20 total for those things. You also know stories of how your parents paid some ridiculously low price of say $10,000 for their house and you are paying hundreds of thousands of dollars for a similar home. Gold used to be less than $50 an ounce in the early 70s and now is nearly $1,000 per ounce. I could go on and on, but you get the point.

Look at what inflation does over time to the dollar
Lets look at how inflation devalues the dollar over time. In the table below, you can look at different rates of inflation and what a $1,000 today will be worth at each 5 year period going into the future.

Year	2%	4%	8%	16%
00	1,000	1,000	1,000	1,000
05	905	818	669	447
10	819	670	448	200
15	741	548	300	89
20	670	449	201	40
25	606	367	134	18
30	549	301	90	8
35	496	246	60	4
40	449	201	40	2

Understanding the numbers
In the previous four part series I just completed on understanding compounding interest, I purposely chose interest rates of 2, 4, 8, and 16 percent since each is double the rate of the previous number, yet the resulting compounding effect is much more than double those of the lower rate. In this series of articles on inflation, the same is true in the opposite as inflation compounds its effect by devaluing the dollar over time much more than twice the effect of the lower inflation rate. You can see that $1,000 today will be worth only $449 at 2% inflation, $201 at 4%, $40 at 8%, and only $2 at 16%. Just for fun, at 32% $1,000 today will only be worth $0.002, not even a penny. It would take $5,000 today to be worth 1 cent in 40 years!!!! Hopefully we will never have 40 years of high inflation.

Think about countries you do hear about that have had very high rates of inflation. In that situation, you MUST have some equivalent means of increasing your income at the same or higher rate than inflation or there would be no hope of maintaining your standard of living. Also, that assumes everyone and all things increase at the same rate of inflation to keep the economy in balance. That is extremely, if not impossible to do over a long period of time.

Summary
You can see that a small increase in inflation (from 2 to 4% or 4 to 8%) can cause significant impact on your future ability to buy anything with the same dollar. In next week's article, I will show the same thing in a different way by looking at how investing in an asset that increases with inflation can give you the edge needed to help maintain your lifestyle and why sophisticated accredited investors work hard to identify and acquire such assets in their portfolio as part of their long term investment strategy.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
- - - - - - - - - -

Two Investor Learning Resources:
MarketClub is an online charting system with buy or sell signals designed to help traders research and help time getting in and out of trades as quickly and efficiently as possible. Learn more by copying the following URL into your browser: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8

INO TV is an online collection of over 500 video trading seminars from some of the foremost experts in their areas, designed to teach new and seasoned traders alike from the comfort of their home. Learn more by copying the following URL into your browser: http://ino.directtrack.com/42/3400/195/

- - - - - - - - - -
Your feedback is wanted:
Please provide feedback to our generic email at AccreditedIT@yahoo.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content

Part 4: Compounding interest – Strategies toward wealth

Overview
This is the fourth article of a series covering compounding interest. This series is meant to help investors understand the importance of having money work for you through the power of compounding. The first article provided an overview of compounding by considering the analogy of growth in memory chip transistors since the early 80s. The second article provided visualization of compounding over 40 years against a single initial $1,000 investment. The third article provided visualization of compounding over 40 years against consistent investment of $1,000 yearly split over 12 months. In this article, we will cover several strategies toward wealth leveraging the power of compounding interest in a tax free account.

Disclaimer
The same assumptions in the disclaimer of the second article will be used here as well.

Recap of the previous two articles
In the second article, I showed how a single $1,000 investment at age 25 could grow significantly over 40 years to $2,224 at 2%, $4,940 at 4%, $24,273 at 8%, and $576,923 at 16% interest. My goal was to show that even one small investment can grow significantly over time as the interest earned starts earning more interest which then earns even more interest. The compounding effect becomes more pronounced as the rate of interest goes up since there is more money generated from interest each year which then continues growing at a faster rate. That is the power of compounding. Eventually your money earns more money which then earns even more money. In this case, all you did was provide the small initial contribution. Your money then went to work for you to provide the rest.

In the third article last week, I showed the importance of consistently contributing funds into your tax free account. Using the example of investing a total of $1,000 each year, split over 12 months, you can see the significant difference in the 40 year compounding period to $61,203 at 2%, $98,497 at 4%, $290,917 at 8%, and $3,599,519 at 16% interest. To see the effect of interest earned upon previous interest earned, lets take out all of the contributions the investor put in. Over 40 years, $40,000 was invested ($1,000 per year). Now remove $40,000 from each total to get $21,203 ($61,203 - $40,000) for 2%, $58,497 for 4%, 240,017 for 8%, and $3,559,519 for 16% interest. All of these totals were due to compounding of interest at the different rates.

Lets look closer at the effect of compounding
To further show the power of compounding, lets take a closer look at the difference between the different interest totals. As stated in a previous article, you would expect the 4% interest total to be twice as large as 2% total. In fact, the 4% interest compounding total of $58,497 is almost three times more than the 2% interest compounding total of $21,203. The effect is seen even more as we compare the 8% interest total of $240,017 to the 4% interest total of $58,497, a little over four times as much. The 16% interest total of $3,559,519 is nearly fifteen times the 8% interest total of $240, 017. So, even though the difference between each interest is twice the next level, the resulting compounding interest earned goes from nearly three times the amount (between 2% and 4% totals) to almost fifteen times the amount (between the 16% and 8% totals). If I carried this further to 32% (twice 16%), the resulting interest compounding would be staggering. This is why the best sophisticated accredited investors strive to, and many do, consistently earn strong compounding rates on their total investment portfolio.

The yearly COLA strategy to increase your contributions
Looking at the importance of having interest earn interest upon interest, it makes sense to try and get as much money into your tax free account as possible in the early years. It would be great if a 25 year old employee would have enough free cash for investing at the full IRS contribution limit ($16,500 for 2009). Starting out at the age of 25 with such a strong start contributing $16,500 yearly would produce significant ending balances after a 40 year career of $1.4M at 2%, $3.2M at 4%, $15.9M at 8%, and $376M at 16%. However, not many new employees have the ability to start out investing so much of their salary. Therefore, I suggest starting out small and working their way up through the yearly half Cost of Living Adjustment (COLA) strategy.

Every year most employees get some amount of yearly salary increase due to inflation (a.k.a. COLA in some professions). I realize these unusual economic times mean many will not, but I will assume those times will get better soon to where the usual increases will return.

COLA strategy variation #1 – half of the COLA into investments
With this strategy, the employee would increase their tax free account contributions by half of this increase each year. As an example, if the employee receives a 2% salary increase, then he or she would increase contributions into the tax free account by 1% (1/2 of the 2% pay raise). This way contributions are increased without the employee missing the money. As a bonus, the employee also gets the remaining money as an increase. In actuality, the employee would see more than a 1% increase since the 1% contribution into the account comes before taxes.

COLA strategy variation #2 – full COLA into investments
Since funds invested in a tax free account are usually before tax, you could put the full COLA into your tax free account and still get an increase in salary. If the employee put the full 2% into the account, he or she would still get a take-home salary increase since the COLA increase is not taxed when being put into the account. The employee should strive to continue this strategy until the yearly IRS contribution limit has been reached. At that point, continue contributing at the IRS limit as it changes each year. That hard work is then done since the employee would be at maximum contributions and have a strong habit of saving/investing money.

Lets look at an example:
If the employee was in a 30% tax bracket and making $50,000 per year, the 2% COLA raise would be $1,000 (2% of $50,000). If the raise is not put into the account, then the employee would pay 30% of the $1,000 in taxes, or $300. By putting the full $1,000 into the tax free account, the employee saves the $300 in taxes and therefore will increase the yearly take-home salary by this amount. The end result is the employee has increased contributions each year in the account while also still enjoying an increase in take-home pay.

The “Automatic Pilot” strategy to wealth
Rather than contributing a set amount into your tax free account yearly, have the contributions put in auto-pilot. As mentioned above, most people get a raise each year. It would be easy to forget to increase your tax free account contributions if they were set at a specific dollar amount. Instead, contribute a percentage of your salary into the account. That way, as your salary increases, so does your contributions. In this case, if you get a 2% raise and contribute 10% of your salary into the tax free account, then your contributions would go up by 10% of the 2% salary increase. Just be careful not to let your contributions grow to exceed the yearly IRS contribution limit.

Summary
As we have seen over the course of this series on compounding interest, compounding is a key strategy to generating wealth. The more you can get your money to work for you, the sooner you can reach our financial goals. I hope these articles on compounding have provided insights through the various examples that may not have been that obvious before. This is why so many financial advisors highly recommend that the one of the first investment goals of any investor should be to maximize their tax free accounts. You may think a $2,500 yearly contribution into an IRA account may not grow into much. As you can see in these articles, it can grow into a significant amount, even if you don’t invest in anything else. Having a strong habit of investing into these accounts provides a strong foundation toward becoming a truly successful investor. Hopefully, your account balance will grow large enough for you to become accredited and have access to other investments that are not available to the ordinary investor. The key is being a disciplined and consistent investor with strategies and goals that define a plan of action toward wealth.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/.

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Part 3: Compounding interest – Compounding of contributions

Overview
This series is meant to help new investors understand the importance of having money work for you through the power of compounding. This is something most sophisticated accredited investors are keenly aware of and use as a key component of their investment strategy. This is the third article of the series. The first article gave an overview of compounding by considering the analogy of growth in memory chip transistors since the early 80s. The second article provided visualization of compounding over 40 years against a single $1,000 investment. This third article will provide visualization of compounding over 40 years against consistent investment.

Disclaimer
The same assumptions in the disclaimer provided in last week’s article will be used in this article as well.

Example of consistent contributions into a compounding investment
Assume, at age 25, a new employee starts contributing into a tax free account provided by his employer. In this case, the account begins with a zero balance, no initial contribution. This will allow us to focus solely on the effect of compounding interest against a consistent investment plan. In this example, the employee gets paid once a month. Also, this person will invest a total of $1,000 each year split over 12 months, or $83.33 monthly ( this is $1,000 divided by 12 months).

Lets now look at the effect of compounding interest over time against a monthly $83.33 investment at different interest rates. In the table below, I will show what the account balance will be at the end of each 5 year period for the different interest rates shown:

Year	2%	4%	8%	16%
00	0	0	0	0
05	5,254	5,525	6,123	7,586
10	11,060	12,271	15,246	24,381
15	17,476	20,508	28,837	61,561
20	24,566	30,565	49,085	143,870
25	32,402	42,844	79,252	326,087
30	41,060	57,837	124,197	729,480
35	50,629	76,144	191,157	1,622,514
40	61,203	98,497	290,917	3,599,519

You may not think it is worth saving only $83.33 monthly or about $2.75 daily into a retirement account. However, this example clearly shows that this $1,000 yearly investment into a tax free compounding account can grow into a very large amount over 40 years without doing anything else by letting that money work for you. Historically, most advisors say you can count on an 8% return from being invested in the stock market. Using 8%, your yearly $1,000 total investment would grow into $290,917 after 40 years. You can contribute any multiple of $1,000 and simply multiply the $290,917 40 year total by that multiple. So, if you contribute $2,000 annually over 40 years, it would grow to $581,834 (this is $290,917 x 2). Similarly, if you contribute a total of $5,000 each year, then it would grow into $1,454,585 ($290,917 x 5).

Understanding the effect of compounding against consistent investment
Now, look at the fact that each interest rate evaluated above is twice the previous interest rate: 4% is twice 2%, 8% is twice 4%, and 16% is twice 8%. I did this to illustrate the difference between compounding as interest rates double.

Notice the differences between the interest rates at each 5 year period described below in relation to the yearly $1,000 total contribution:

At year 5, the total contribution by the investor is $5,000. The account balance difference between all interest rates shown is not that much ranging from $5,254 to $7,586. However, the 16% interest balance is approximately 50% larger than the total contribution.

At year 10, the total contribution by the investor is $10,000. The account balance difference between all interest rates shown is more pronounced ranging from $11,060 to $24,381. The 16% interest balance is well over twice the total contribution.

At year 15, the total contribution by the investor is $15,000. The account balance difference between all interest rates shown is much more pronounced ranging from $17,476 to $61,561. The 8% interest balance is nearly twice the total contribution while the 16% balance is over four times the total contribution.

At year 20, the total contribution by the investor is $20,000. The account balance difference between all interest rates shown is very pronounced ranging from $24,566 to $143,870. The 8% interest balance is well over twice the total contribution while the 16% balance is over seven times the total contribution.

At year 25, the total contribution by the investor is $25,000. The account balance difference between all interest rates shown is extreme ranging from $32,402 to $326,087. The 8% interest balance is over three times the total contribution while the 16% balance is over thirteen times the total contribution.

At year 30, the total contribution by the investor is $30,000. The account balance difference between all interest rates shown is more extreme ranging from $41,060 to $729,480. The 4% interest balance is now nearly twice the total contribution. The 8% interest balance is over four times the total contribution while the 16% balance is over twenty four times the total contribution.

At year 35, the total contribution by the investor is $35,000. The account balance difference between all interest rates shown is even more extreme ranging from $50,629 to $1,622,514. The 4% interest balance is now over twice the total contribution. The 8% interest balance is over five times the total contribution while the 16% balance is over forty six times the total contribution.

At year 40, the total contribution by the investor is $40,000. The account balance difference between all interest rates shown is even more extreme ranging from $61,203 to $3,599,519. The 4% interest balance is well over two times the total contribution. The 8% interest balance is over seven times the total contribution while the 16% balance is nearly ninety times the total contribution.

Further understanding the power of compounding for consistent investment
Remember, all examples above relate to the same yearly $1,000 total contribution. Also, the interest rate was doubled from one column to the next. However, the effect of compounding after 40 years are drastically different. Intuitively, you might think that 16% interest would return twice as much as 8% over time or that 8% would return twice as much as 4%. In fact, we see that there is a HUGE difference in the returns between each double of interest rate over time. Initially we saw there was not that much difference after five years, but the power of compounding started kicking in over time to where you were earning interest upon interest already earned upon interest that money had earned. So, as your money gains new money from interest, that increased balance also started earning interest to where it then earned more interest, etc. That is what I meant by having money work for you. Let your money earn money for you. In this case, you didn’t need to do any more than provide the same yearly $1,000 total contribution.

Summary
Again, compounding is how to make money work for you as the ideal employee that never tires, never complains, always works, continues to get better, becomes self sufficient over time, and can end up paying you through your retirement years. Next week's article will provide strategies for investing in tax free accounts.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html.

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Part 2: Compounding interest – Visualizing the compounding effect

Overview
Last week I began a series on compounding investments (click here for the article). I tried to provide an analogy that most of us are familiar with – the compounding of transistors in each new generation of memory chips. In the mid 80s, you could get a 4,000 transistor memory chip (known as a 4k chip). Today you can get over 4,000,000,000 transistors on a chip known as a 4 gig chip. Chips tend to double in the number of transistor between advancements at an exponential rate over time to where a 4k to 8k memory chip advancement only increased the number of transistors by 4,000 and today a 4 gig to 8 gig memory chip increases the number of transistors by 4,000,000,000, a million times more increase. This is the power of compounding over time.

As mentioned last week, visualize the transistors being dollars compounding over time. Eventually, you can make much more money from the compounding of your funds than from the amount you regularly contribute into the investment. However, the earlier you start a regular contributions into a compounding investment, the larger the compounding effect will be when you are ready to retire. Lets look closer at various examples of compounding to illustrate this point.

Disclaimer
All examples will assume investment in a tax free retirement account of some kind whether it is a IRA, , 401k, 403b, etc. These examples also assume interest is paid at the end of each month on the balance in the account. The amount shown on each line is balance at the end of each time frame (balance at the end of 5 years, 10 years, etc.). These assumptions allow us to focus on understanding the compounding affect alone with no other variables. In reality, other factors such as inflation and taxes when the funds are withdrawn will reduce the value of money over time and taxes when the funds are withdrawn will also reduce what you have for spending. Also, for simplicity, I assume the starting age of a new employee to be 25 years of age with retirement being planned at 65 years of age, which will show the effect of compounding over 40 years.

Example for a single initial $1,000 contribution
Assume a new employee at age 25 contributes $1,000 into a tax free account and never contributes any other funds. Lets now look at the effect of compounding interest over time at different interest rates. In the table below, I will show what the account balance will be at the end of each 5 year period for the different interest rates shown:

Year	2%	4%	8%	16%
00	1,000	1,000	1,000	1,000
05	1,105	1,221	1,490	2,214
10	1,221	1,491	2,220	4,901
15	1,350	1,821	3,307	10,850
20	1,491	2,224	4,927	24,019
25	1,648	2,714	7,340	53,174
30	1,821	3,314	10,936	117,717
35	2,013	4.046	16,293	260,602
40	2,224	4,940	24,273	576,923

You may not think it is worth saving only $1,000 into an account without starting a ongoing contribution plan. However, this example clearly shows that $1,000 can grow into a much larger amount over 40 years without doing anything else by letting that money work for you (see last week’s article on having money be your best employee). Historically, most advisors say you can count on an 8% return from being invested in the stock market. Using 8%, your single $1,000 deposit would grow into $24,723 after 40 years. This says, for every $1,000 you deposit, each of those $1,000 will grow into $24,723. So, if you contribute $2,000 initially at age 25, then at age 65 it would grow to $49,446 (this is $24,723 x 2 since you contributed 2 x $1,000 or $2,000 initially). Similarly, if you had contributed $5,000 initially, then it would grow into $123,615 ($24,723 x 5).

Understanding the effect of compounding
Now, look at the fact that each interest rate evaluated above is twice the previous interest rate: 4% is twice 2%, 8% is twice 4%, and 16% is twice 8%. I did this to illustrate the difference between compounding as interest rates double.

Notice the differences between the interest rates at each 5 year period described below in relation to the initial $1,000 contribution:

At year 5, the account balance difference between all interest rates shown is not that much other than the fact that the 16% interest account has already doubled.

At year 10, the 8% balance has doubled and the 16% balance has almost increased five times over the initial $1,000 amount.

At year 15, the 8% balance has more than tripled while the 16% balance is now almost 11 times more than the initial $1,000.

At year 20, the 4% balance has finally doubled while the 8% balance is now almost 5 times more and the 16% account is 24 times more.

At year 25, the 8% balance has increased to seven times and the 16% account has increased to 53 times the initial contribution.

At year 30, the 4% balance has tripled, the 8% balance is now nearly 11 times more, and the 16% balance is now almost 118 times more than the initial contribution.

At year 35, the 2% balance has finally doubled. The 4% balance is now four times more, the 8% balance is now 16 times more, and the 16% balance is now nearly 261 times more than the initial contribution.

At year 40, the 2% balance is still just a little over double. The 4% balance is now nearly five times more, the 8% balance is over 24 times more, and the 16% balance is a tremendous 577 times more than the initial contribution.

Further understanding the power of compounding
Remember, all examples above started out with the same $1,000 initial contribution. Also, the interest rate was doubled from one column to the next. However, the effect of compounding after 40 years are drastically different. Intuitively, you might think that 16% interest would return twice as much as 8% over time or that 8% would return twice as much as 4%. In fact, we see that there is a HUGE difference in the returns between each double of interest rate over time. Initially we saw there was not that much difference after five years, but the power of compounding started kicking in over time to where you were earning interest upon interest already earned upon interest that money had earned. So, as your money gains new money from interest, that increased balance also started earning interest to where it then earned more interest, etc. That is what I meant by having money work for you. Let your money earn money for you. In this case, you didn’t need to do any more than provide the initial $1,000 contribution. You could have walked away and not done another thing (assuming you are able to get in an investment that consistently returns the rates I’ve illustrated each year without further management by you). Your money does all of the work.

Portfolio management for consistent returns over time
Many people leave their funds in CDs which are now paying very low returns. However, these funds are very secure. Higher rates of return usually mean you are investing in a higher risk investment where your funds are at more at risk of loss. Many accredited investors finds ways of diversifying risk over several investments that each vary in the level of risk and therefore in associated rates of return to try and generate a fairly consistent overall portfolio rate of return that performs in both good and bad times. This is called portfolio management. Some accredited investors become very proficient at this to the point of being able to generate high average returns over long periods of time. Consistently earning the higher returns provides the large multiplication factors you see above that the higher interest rates provide.

Summary
Again, compounding is how to make money work for you as the ideal employee that never tires, never complains, always works, continues to get better, becomes self sufficient over time, and can end up paying you through your retirement years. Read the next article in the series "Part 3: Compounding interest – Compounding of contributions" to learn how a consistent monthly contribution to a tax free investment account can grow into significant amounts over 40 years of consistent investment.

Copyright 2009 Ole Cram, President of Marcobe Investments, Inc.
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An Investor Resource: MarketClub gives you the tools you need to build a successful portfolio. Researching and planning trades can take hours, and let's face it, traders don't have hours to waste. What you need is a tool to give you an edge on the markets and to help you make educated decisions based on the technicals and not your emotion. MarketClub puts all of your research tools in one easy to use package that together gives you the edge you need to build and manage your investments.

Unique features:
Smart Scan: Scans more than 230,000 symbols to identify trending patterns that fit the exact parameters of what you're interested trading. Quickly look through stocks, futures, etf's and mutual funds for volume, price and exchange criteria that you choose.
Trade Triangles: Created by a former professional floor trader and engineered by a technical prodigy. Trade Triangles are easy to read buy and sell signals on customizable charts. By using these buy/sell signals, traders enter trends which puts the odds in their favor that a movement will continue.

Alerts: MarketClub can quickly alert you of major market occurrences that directly affect your portfolio. You customize your parameters and we will send you a message when symbols in your portfolio have hit a new price breakout, net change, triangle issued, 1,3,4 or 52 week high or low and strong or weak DMA.

To learn more about these features and more visit: http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8Just say "maybe." You have an invitation to take a 30-Day Risk Free Trial. If for some reason MarketClub doesn't fit your trading style, we will refund the full amount no questions asked. To give your trading an edge add MarketClub to your toolbox. http://www.ino.com/info/69/CD3400/&dp=0&l=0&campaignid=8

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Your feedback is wanted:
Please provide feedback to our generic email at MarcobeInvestmentsInc@gmail.com on questions you have, ideas for future articles, and any other thoughts that could lend themselves to future articles for the benefit of all readers.

Marcobe Investments, Inc., is a corporation that invests in various oil and gas ventures and refers accredited investors, investment managers, financial advisors, investment funds, and others to the associated oil producer of these projects for their consideration. We are not licensed to sell any interest in a project, nor are we registered advisors.

This article was posted at Accredited Investor Blog: http://accreditedinvestortalk.blogspot.com/. Key past articles related to investments in oil and gas can be found at http://www.MarcobeInvestmentsInc.com/Oil_and_Gas_Investor_TOC.html.

Disclaimer: This article is provided for educational purposes only and is not meant to be a substitute for tax, legal, financial, or other registered professional advice for your specific situation. Always seek the advice of a professional before making any related decision. Sphere: Related Content