An Actual Tale


AN ACTUAL TALE

“HOW FINANCIAL ADVISORS LIE”

 

 

My daughter recently asked me to explain how advisors calculate stock market returns.  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 about 2%.  The best way to explain what my daughter experienced is to eavesdrop on a typical conversation between two investors circa 2005–2012.  We’ve heard it countless times.  You might even have experienced it yourself.

The one fellow says to the other, “Everyone tells me the stock market has averaged 10–12% per year.  They tell me I have to buy and hold stocks because they are the best investment for the long run.  I don’t get it.  When I look at my statements, I haven’t made any money in a decade.  Am I ever going to make any money?  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 decade either.”

If the above sounds familiar, you might want to understand how to calculate rates of return 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 many and repeats often.  It is a conversation investors have and will continue to have as long as the stock market is volatile and their timing is less than stellar.  It teaches us the difference between an actual return and an average return.  For the math inclined, an actual return is the same as the geometric return, and is what you actually make over time.  An average return is the same as the arithmetic return, and quite frankly should have no place in any serious discussion about investments.  This tale will show you why and explain the 2% difference my daughter kept running up against.  It also teaches us about how long the stock market can go without making the investor any money.  This is a tale about you.

I bet many share the recent 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 this collective advice means.  You are only getting half the story.  The advice thatEveryone” 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 as well 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 these types of rules of thumb mean.  After many years, I’ve learned that “Everyone” is usually 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.  He is famous for his line, “In the long run we’re all dead.”  There are different opinions by 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 this way, you’ve already missed the boat.  The long run has nothing to do with measured time.  If it did, you would have heard the time frame defined.  I have yet to hear anyone say it’s more than five 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, the long run means on average.  Let’s play the substitution game.  Does this mean, “On average we’re all dead?”  Well of course it does.  However, 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.  Once you do, and assuming the future looks somewhat like the past, you will understand what this 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 during which 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 some recent 10+-year periods.  Does the same hold true for shorter periods?  The answer for shorter periods is even worse.  Losing money over short periods, such as five years, is a routine occurrence in the stock market.  Does this surprise you?  What if I were to say there have been multiple periods during which 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 appeals to you?  If you said no, then you are one of the many who needs to have a portion of 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.

Although 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.  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 that they can be harsh or very rewarding.

So why do I call this tale An Actual Tale, and why is the subtitle How Financial Advisors Lie?  The reason is there is a significant difference between an average return and an actual return.  They are not really lying.  They are just skewing things in their favor.  Let me pose this as a series of questions.

Is it possible for the stock market to average 10.93% over the 16-year period ending in 2010 while only actually making 8.71% or a 2.22% difference?  Is it possible for the stock market to average a positive return while in fact you actually lose money?  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 tothe 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, from 1995 through 2010, on the Russell 1000 large cap index, a good representation of the stock market, 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.  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 by 2010.  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 by 2010, or approximately 38% more.  This is how financial advisors lie.  Although the market did average 10.93%, you actually only made 8.71%, or a 2.22% difference.  This is why my daughter’s math did not add up.  Also please note, I did not cherry pick the dates for this tale.  I have done extensive analysis using rolling 10- to 20-year periods, and the results are surprisingly close to the 2.22%, depending on the volatility of the stock index you use.  The more volatile the stock index, the larger the difference between the actual and the average.  The conclusion is a robust one.  The math doesn’t lie.

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 difference or almost every 10 year period I examined dating back to 1926 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 posed earlier in this tale 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 although 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 ofthe big lie”—average returns do not equal actual returns.

For those who are interested, the reason you lost money despite a positive average gain over the 10 years is due to the mathematics of recovery.  When you lose money on an investment, you must make a higher percentage rate of return after a loss to get back to your starting point.  As an example, if you lose 20% on your money, you must make 25% in order to get to breakeven.  If you lose 50%, you must make 100% in order to breakeven.  Therefore, losses hurt more than gains, and the larger the loss the larger the hurt.

Lastly, “Does the average return always exceed the actual return for the stock market?”  The answer is yes.  The reason is that the stock market has years during which it loses money, and this causes the average vs. actual disparity.  The following simple math explains why this happens.  If one year the stock market goes up 50% and the following year it goes down 50%, we all know the average return for the two-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.  The stock market has long periods during which investors either make very little money or 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 even though they should be for those looking to build wealth. 

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.  This means you will make 2.22% less in reality than what the market averages.  This also means that you are now responsible for always asking 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 who can.

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.

There are investment products in which 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 average return to equal actual return, the investment can never have a losing period.  It can have a 0% return period, but not a losing period.  These types of investments are appealing because what you see is what you get.

Always remember that for any time series of returns during which there are periods of losses, average will always overstate actual.  So what are some other indices to consider?  The answer of course depends on what you want to measure.  An analysis of the S&P 500 from 1928 through 2014 tells us the actual return was 9.60% per year.  The average return was 11.53%, for a difference of 1.93%.  What should you do with this information?  Because this is a tale, and because most stock indices are more volatile than the S&P 500, I would stick with the 2.22%.  It’s easier to remember.    

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