An Actual Tale

US CONFIDENTIAL COVERSHEETS

US CONFIDENTIAL COVERSHEETS (Photo credit: Wikipedia)

An Actual Tale

“How Financial Advisors Lie”

My daughter recently asked me to explain how the stock market calculates the rates of return that are so often quoted because according to her calculations–the numbers didn’t add up.  She kept telling me that something was seriously wrong because no matter how she looked at the numbers they were consistently lower by between 2% to 2.5%.  The best way to explain what my daughter was experiencing is to eavesdrop into a typical conversation between two investors.  It’s a conversation we’ve heard countless times and I’m sure it will sound familiar to you as well.

The one fellow says to the other, “Everyone tells me the stock market has averaged 10-12% per year and I have to buy and hold stocks because they are the best investment for the long run.  But when I look at my statements I haven’t made any money in the last 10-12 years.  Am I ever going to make any money and what exactly is the long run?  What gives?”  To which the other fellow replies, “I’ve heard the same thing but never really understood it.  What I know for certain is that I haven’t made any money in the last 10 years either.”

If the above sounds familiar you might want to understand how rates of return are calculated so that you have a better understanding of the stock market.  This is not a specific tale about an individual.  It is a collective tale that rings true for most.  If you’ve only been investing for the last 10-12 years you can probably relate even better and so it’s a tale about you.

I bet many share this decade-long frustration and understandably so.  It’s been a decade since folks could look at their stock portfolio with admiration.  Does this mean the advice to buy and hold stocks for the long run is wrong?  Let’s clarify what this advice actually says and let’s add some history and context to what is meant by this collective advice.  The advice or what Everyone says, though true to an extent, is confusing since most people don’t have a clue how money compounds over time in the stock market, they are uncertain about what the long run means and don’t understand the way the stock market actually makes these types of returns.  This tale is my attempt to add some common sense insight so that you understand what is meant by these types of rules of thumb.  After many years, I’ve learned–Everyone is almost always wrong.

Let’s ask a basic question first.  What is the long run?  I’ve been fascinated with trying to understand what the long run means ever since I first read the quote from the famous economist John Maynard Keynes where he says “In the long run we’re all dead.”  Much has been written about what he meant.  However, it is important to relate it to what I think it means to an investor.  So is the long run a year, a decade, two decades or more?  If you are thinking in terms of a time frame, you’ve already missed the boat.  The long run has nothing to do with time.  If it did you would have heard the time frame defined.  I have yet to hear anyone say it’s more than 5 years or more than 10 or any quantifiable far off number.  So what is the long run?  I believe it is a term used by economist to explain the way things should work in the context of whatever model they are espousing.  In the case of the stock market model or the investing model what they mean by the long run needs to be interpreted by us as “on average.”  So does this mean that “On average we’re all dead?”  Well of course it does.  But we should try to get some sense of what to do before the inevitable.  To this end, it’s important to understand some stock market history and what it means to your life and portfolio.

What if I were to tell you that in the last 110 years of US stock market history there was a 20 year period where the stock market made you virtually 0% return.  Furthermore, there were other distinct periods where for more than 10 years you made virtually 0%, including the most recent 10+ year period.  What about 5 year periods where you actually lost money and a lot of it?  Would you be surprised?  What if I were to say there have been multiple periods where if you got in at the wrong time you lost more than 50% of your money in a relatively short time frame of less than 30 months.  Would this be something that you would invest your money into?  If you said no, then you are one of the many that needs to have their money invested in asset classes other than just the stock market.  Don’t be ashamed however, if you said no, you are like most people.

While the stock market offers potential rewards, it also offers potential losses.  In the case of the stock market, I believe timing is everything.  It’s the reason why my investment methodology is dynamic and considers a wide range of asset classes for inclusion in my investable universe.  See An Alto Mar Tale to get an inkling of investment methodologies I consider attractive.  I use these long periods of stock market dullness or losses to illustrate once again the point of what the long run means to you as an investor.  If you keep thinking of it as a time period you are in trouble.  It is an average but like all averages there are deviations from the average and you must be aware they exist and they can be harsh or very rewarding.

So why do I call this tale An Actual Tale and why is the subtitle called “How Financial Advisors Lie?”  The reason is because there is a significant difference between an average return and an actual return.  Let me pose this as a series of questions.

  1. Is it possible for the stock market to average 10.93% over the 16 year period ending 2010 while only actually making 8.71% or a 2.22% difference?
  2. Is it possible for the stock market to average a positive return while in fact you actually lose money?
  3. Does my average return always exceed my actual return?

If you answered yes to all of these, I congratulate you.  If you didn’t then you have fallen victim to The Big Lie and you need to understand what is going on and should read further.

Let me be specific.  If you download the annual returns on the Russell 1000 large cap index, a good representation of the stock market, from 1995 through 2010 you notice a few things.  You see some positive years and some negative years.  You see some large positive years and some large negative years.  The actual annual results are at the end of this tale and had you invested for the 16 year period you would have earned an actual compounded growth rate of 8.71%.  This means if you started with $10,000 in 1995 and had a stable return every year of 8.71% your capital would have grown to $38,039.20.  However, if you were to take the return in each of the 16 years, add them up and then divide by 16 your average return would have been 10.93%.  Had you been able to compound your money at this average rate instead of $38,039.20 you would have $52,575.60 or approximately 38% more.  This is How Financial Advisors Lie.  Though the market did average 10.93%, you actually only made 8.71% or a 2.22% difference.  I almost called this tale a 2.22% tale because this approximately 2.22% difference between what you think the market will make you and what it actually makes you has been the case for almost every period I examined dating back to 1926 that lasts 10 years or more and of course 2.22% is easy to remember.  So from now on, when you hear someone say the market has averaged “some low double digit number” I want you to understand it is actually “some low double digit number less approximately 2.22%.”  Commit this to memory and use it as a rule of thumb.

The second question I asked was, is it possible for the market to average a positive return while you actually lose money?  The answer is yes.  For example, during the 10 year period from 1999 through 2008 the Russell 1000 Large Cap Index averaged 1.02% while the actual return was an annualized loss of 1.09%.  In this case it was a 2.11% difference and very close to my 2.22% rule of thumb.  This means that while your mind might register that your $10,000 would have grown to $11,763 it actually decreased in value to $8,962.  Once again, you are victim of The Big Lie-average returns do not equal actual returns.

Lastly, does the average return always exceed the actual return for the stock market?  The answer is yes.  The reason is because the stock market has years where it loses money and this causes the average vs. actual disparity.  The following simple math explains why this happens and I explain it in further detail in A Tale of Recovery.  If you have a year where the stock market goes up 50% then it goes down 50% the next year we all know the average return for the 2 year period is 0%.  However, if you invested $10,000 at the start of the period you only have $7,500 at the end of the period for an actual loss of 25% which translates to a compounded annual loss of approximately 13.40%.  Once again, The Big Lie- average returns do not equal actual returns.

So let’s summarize what we have learned in this tale.

1)    The stock market has long periods where investors not only will make very little money but will actually lose money.  These periods are much longer than people understand and can easily exceed 10 years.  This means that portfolios with over-weightings in equities are not for everyone.

2)    There is a significant difference between an average return and an actual return.  I like to use the rule of 2.22% so that people can remember it.  I like it because breakfast places like Denny’s are always offering a 2-2-2 special and it’s easy to jog your mind this way.  This means you will make 2.22% less in reality than what the market averages.  This also means that you are now responsible to always ask the question—“Is this an average return or an actual return?”  If the person selling you an investment product can’t answer the question, then you need to find someone that does.

3)    The long run is not a measure of time.  It means “on average” and we have learned that “on average” does not mean “in actuality.”  You should only deal in actuality.

4)    There are investment products where average returns resemble actual returns and are not subject to the 2.22% rule but they are a special case or type of investment product.  The key is that in order for this to happen the product can never have a losing period.  It can have a 0% return period but not a losing period.  To find out more about these types of investment products, Ask Financial Tales.

This is the first tale I write to explain why I have after years of working with investors developed a proclivity to portfolios that have High Mar Ratios as well as for investment products that don’t lose money.  It is also why I am not a fan of static portfolio allocations and gravitate to fundamentally driven dynamic portfolio allocations where you diversify by risk and not just assets and where you actively manage volatility.  I encourage the reader to read An Alto Mar Tale after this one.  It will make you see the world through a completely different prism.

Table For An Actual Tale: How Financial Advisors Lie

How Financial Advisors Lie

An analysis of this table leads to only one conclusion and that is that actual returns do not equal average returns.  We can see in column 3 the returns of the Russell 1000 Index for each of the 16 years from 1995 through 2010.  We can see that a $100,000 investment would have grown to $380,392 at an average return for the 16 years of 10.93%.  You can calculate the 10.93% by adding each of the 16 years and dividing by 16.  However, had an investor been able to find a fixed return of 8.71% over the same time period, their $100,000 would have grown to slightly more than in the Russell 1000 Index.  The difference between 10.93% and 8.71% is 2.22%.  Don’t be a victim of The Big Lie.  Always remember that for any time series of returns where there are periods of losses, average will always overstate actual.

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