How to become a millionaire in 3 easy steps (Level 3)

Lever 3: How you invest. How to become a millionaire in 3 easy steps (Level 3) Say your goal is to have a million in less than 20 years...

Lever 3: How you invest.
How to become a millionaire in 3 easy steps (Level 3)
Say your goal is to have a million in less than 20 years, that you have $250,000 put away and that you are taking great pains to save $30,000 a year. Even at that aggressive pace, you wouldn't hit your deadline if your portfolio simply kept up with inflation. However, if you earned a modest 1% a year after inflation, you'd get to the equivalent of $1 million today in 18 years ($1.7 million in nominal dollars). Every percentage point shaves off a little more time.

Of course, the strategies that promise the greatest potential returns also present the greatest potential for loss so you'll want to avoid serious long shots like buying manganese futures or trading the Thai baht. A few saner strategies, in ascending order of risk:

SAFE BET: Cut your costs.
The returns you collect from mutual funds will always be hampered by the expenses you pay. Don't think reducing costs makes much of a difference?

At MONEY's request, Vanguard ran a series of simulations to see how various asset mixes are likely to perform over the next 20 years.

Turns out, a typical 60% stock/40% bond portfolio, charging 1.25% a year, has a great probability of generating at least 5% annually over the next two decades. At that rate -- assuming 3% inflation, current savings of $250,000 and additional contributions of $15,000 a year -- you'd get to a million in 23 years.

But if you were able to boost those returns to 6%, which you could do by reducing portfolio costs to 0.25%, you'd make it in 20 years.

You can easily create a 60/40 portfolio with an overall expense ratio under 0.25%. For example, put 40% in Schwab Total Stock Market Index (SWTSX) (expense ratio: 0.09%), 20% in Vanguard Total International Stock (VGTSX) (0.26%) and 40% in Vanguard Total Bond Market (VBMFX) (0.22%). All three are on the MONEY 70, our list of recommended mutual funds and ETFs.

Wondering if you couldn't achieve similarly positive results simply by picking better funds? Good luck consistently finding managers that will consistently outperform the market, says Thomas Idzorek, chief investment officer for Ibbotson Associates.

LESS SAFE BET: Tilt toward small bargains.
In this strategy, you would keep your overall stock-to-bond split the same. You'd just move some of your equity allocation out of big blue chips and into small-cap value stocks -- shares of small companies that are being overlooked or once-larger companies that have fallen on hard times and are selling at attractive prices.

Between July 1927 and the end of last year, the average small-cap value stock gained more than 14% annually, according to Ibbotson Associates, vs. 9.8% for the S&P 500.

It's not all roses, however: Such stocks tend to be more volatile than your garden-variety blue chip because they've either been battered or lack competitive advantage.

Also, there have been long stretches when they have been out of favor, such as the mid- to late 1990s. Finally, since these shares have returned nearly three times as much as the broad market over the past decade, it's hard to imagine they can keep churning out outsize gains -- at least in the short run.

But in the long term "there's no reason to believe small-cap values won't sustain their advantage," says Paul Merriman, founder of Merriman Capital Management.

So if you have at least two decades to invest, gradually shift small amounts from large-caps into small value through a fund like T. Rowe Price Small Cap Value (PRSVX), which is on the MONEY 70. Do so until the shares are a quarter of your equity allocation, and history says you'll see a real impact. Since the late 1920s, a 60% stock/40% bond portfolio with this small-cap value tilt returned 9.7% a year, while a traditional 60/40 index portfolio returned 8.7%. With that edge, in 25 years you'd turn $200,000 into $970,000 in today's purchasing power vs. $770,000 without the small-cap bent.

RISKIER BET: Step up your stock stake.
History shows that the simplest thing you can do to boost long-term investment performance is to dial up your equity exposure. Since 1926, the average 50% stock/50% bond portfolio gained 8.2%, according to Vanguard. Raising the stock stake just a bit, to 60%, would have resulted in annualized gains of 8.7%.

There's a trade-off, of course: The more you tilt toward stocks, the higher your chances of losing money in a single year. A 50/50 portfolio has lost value in 17 calendar years since 1926; a 60/40 has fallen 21 times; a 70/30 sank in 22 years; and an 80/20 dipped in 23.

You'll suffer the most if the market dives near the end of your time horizon, since you won't have a chance to recover. For example, if you entered 2008 the last year the market suffered losses -- with $1 million, you'd have had $798,000 at the end of the year with a 60/40 mix.

Were your portfolio instead invested at 50/50, your million would've ended up at $840,000. So even if you think you can handle a greater stock exposure now, be sure to reduce the percentage as you approach your goal date.

RISKIEST BET: Leverage your equities
.
Yale professors Ian Ayres and Barry Nalebuff think there's a problem with how we invest. When you're young and can tolerate being all in equities, you don't have much money. When you're older, you may want to be only 50% in stocks, but in dollar terms that dwarfs how much you had in the market in your youth.

Therefore, the duo have controversially posited that young investors -- those in their twenties and thirties -- should leverage their equity positions, sometimes by as much as 2 to 1. In other words, if you have $20,000 to invest, not only should all of that go into stocks, but you should borrow an additional $20,000 so you have $40,000 in equity exposure.

Ayres and Nalebuff crunched the numbers going back to 1871 and found that over a lifetime this strategy consistently beat the traditional 110-minus rule (where you subtract your age from 110 and put the resulting percentage in stocks). Their method resulted in accounts 14% larger, on average. Even in the worst case, their approach came out ahead by 3%.

These professors aren't talking about taking a flier on a single stock. They recommend investing in the broad market, which you can do using a margin account at your brokerage to buy an index fund or ETF.

Or you can leverage your bets through options contracts that give you the right to buy or sell an index, such as the S&P, in the future. You'd reduce your stock exposure as you age. In fact, the extra risk you take in your twenties and thirties would allow you to be even more conservative -- possibly keeping as little as 20% in equities -- toward the end of your career.

There are, of course, caveats: While the profs say that someone in his forties could still benefit by leveraging -- say, 1.2 to 1 -- older folks or those with a time horizon of less than 20 years should think twice about trying this strategy. Leverage will magnify any losses you suffer in equities.

And that could put you in dire straits if your brokerage issues a margin call, meaning it requires you to sell some of your holdings because your account value is too low. (This is also a risk for young people, but less dire.) Finally, if you work in a volatile industry where your future income looks shaky, you can't afford this type of risk. But if you've got a stable job and decades to invest? It may just make you a million bucks.


Disclaimer: The Content Or Opinions Expressed On This Web Site Are Not To Be Interpreted As Medical Advice. Please Consult With Your Doctor Or Medical Practitioner Before Utilizing Any Suggestions On This Web Site.

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African Millionaires: How to become a millionaire in 3 easy steps (Level 3)
How to become a millionaire in 3 easy steps (Level 3)
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