The Investor’s Dilemma

It seems natural that an investor wants to make more money and also wants to avoid losing money, which is why chasing new money rates sounds like it would be a good idea. Some rate-chasers are more conservative than others, and will only move to a higher rate if the perceived risk is not higher than where their money is parked right now. But, this doesn't change much about their general attitude toward investing. And, that general attitude and approach to investing is relatively short-term (1-5 years, and often less than that) and to seek the highest hypothetical rate of return possible within that short time frame. Again, some investors would quibble that they want the highest return with the lowest risk, but the general approach is the same. They are seeking higher rates of return on their savings to the exclusion of nearly everything else. When a bank offers "20x higher than the national average!" on a savings account, it is not advertising to investors. It is advertising to rate-chasers, who are not committed to a long-term investment strategy.

When an investment firm offers to convert a policyholder's whole life insurance policy into venture capital for some 1-in-a-million startup venture, it's not investing. It's speculation and, these days, probably more like gambling. When a life insurance company publishes double-digit crediting rates on indexed universal life insurance with bonuses or charge-funded multipliers, it's not advertising to long-term savers and investors. It's appealing to rate-chasers.

Rate-chasers are not long-term thinkers. They are committed to gimmicky tactics and short-term speculations, no matter how "conservative" they might appear to be. They are short-term thinkers.

Rate-chasers are nearly always asking for pat answers to their investing questions. Instead of wanting to learn investing fundamentals, they want to know the specific investments they should be investing in right now. And, when those investments turn sour, they'll be back at the advice trough begging for more hot stock tips, or insider information, so they can know what specific investment they should be investing in next. They are not always bad people, per se. But, they are lazy thinkers. Many of them simply don't want to put in the effort to learn. They want to be fed the easy answers they can act on immediately, instead of applying thought, discipline, and control to their investing actions. They never lead themselves toward victory and success. They only know how to follow others. 

This essay is not for rate-chasers. It is for thoughtful savers and long-term investors. If you've read this far, then most likely, this article is for you. And, even if you think you have already made up your mind, it's still probably for you anyway.

Basic Investment Types

Since the term "investor" seems to have multiple different meanings these days, from the professional day trader to the typical 401(k) investor socking money away for retirement, we'll start with a sketch of the basics so that we're all on the same page.

Stocks

Stock represents an ownership stake in a company. When you buy (and own) stock, you own a piece of a business. Because you own a piece of a business, you’re entitled to its profits — all profits of a company belong to the company’s owners.

For example, if you own stock in Apple, you are part owner of Apple. Now, your ownership in the company gives you limited ownership rights. You can vote for board of director members, you get a share of the profits of the company, and you can attend special shareholder meetings the company holds. At the same time, your liability is limited. If the company gets sued, you’re not on the hook for payment of the judgment. Creditors also can’t come after you to satisfy a debt of the company. Think of yourself as, more or less, a “silent partner” who can subtly influence the direction of management and who occasionally shows up to collect profit-sharing checks.

Bonds

Bonds are debt instruments — loans. When you buy a bond, you are loaning money to either a government (Treasury bonds, municipal bonds, etc.) or a business (corporate bonds). You become the creditor and the government or company issuing the bond becomes the debtor. Because of this, you are contractually entitled to interest payments (except in the case of zero coupon bonds, which are bought at a deep discount and then grow to their full value over time) and a return of your principal at some future date. If a company or government goes bankrupt, you are “first in line” to get your money back (or, at least, you will be repaid before stock holders).

Mutual funds

Mutual funds are financial products unto themselves. They are a sort of “container” for other investments, but they also refer to a specific organizational structure of an investment company. A mutual fund may consist of a collection of stocks, bonds, or both. Mutual funds can also buy other assets, but most investors choose to own equity (stock) mutual funds or bond mutual funds. A mutual fund charges various fees for conducting transactions (buying and selling bonds or shares of stock), administrative, management, advertising, and other expenses. These fees are, collectively, referred to as the “expense ratio.” It is the ratio of expenses to the total assets held in the fund. Expense ratio is calculated each year, and then those costs are distributed or apportioned among all investors who buy into the mutual fund. Some mutual fund companies, like Vanguard, have no outside shareholders and are instead owned its many mutual funds, which are owned by their investors. Other companies are publicly-traded companies in which investors can buy shares of the mutual fund company without actually investing in the mutual funds themselves.

Of all the investments an investor can own, many investors opt for mutual funds.

Other Investments

Obviously, there are other investments. However, it would take entirely too much time to list and explain all of them. A few of the more popular “alternative investments” include:

• Real estate
• Commodities (e.g. gold, oil, wheat, cattle, coal, soybeans, etc.)
• Stock options
• Managed futures
• Forex
• Hedge funds
• Limited Partnerships
• Private equity

If you’re new to investing, you probably won’t be investing in any of these things because, for the most part, they require extraordinary technical skill to manage.

Stock Market Returns: Do Stocks Outperform Guaranteed Investments?

Hendrik Bessembinder, a professor at Arizona State University, compiled the monthly returns for all known listed stocks in the CRSP database to answer this question. His data and findings, which are published in his paper titled, Do Stocks Outperform Treasury Bills?, covers all available stocks from 1926 to 2016. Not just stocks from the S&P 500 or the Dow Jones… all known available stocks.

He found:

"Four out of every seven common stocks that have appeared in the CRSP database since 1926 have lifetime buy-and-hold returns less than one-month Treasuries. When stated in terms of lifetime dollar wealth creation, the best-performing four percent of listed companies explain the net gain for the entire U.S. stock market since 1926, as other stocks collectively matched Treasury bills… 

… Only 27.5% of single-stock strategies produced an accumulated 90-year return greater than one-month Treasury bills. That is, the data indicates that in the long term (i.e., the 90 years for which CRSP and Treasury bill returns are available), only about one-fourth of individual stocks outperform Treasuries. Further, only 4.0% of single-stock strategies produced an accumulated return greater than the value-weighted market…

The results reported here show that most individual common stocks have generated buyand-hold returns that are less than the buy-and-hold returns that would have been obtained from investing in US Treasuries over the same time periods. Stated alternatively, the fact that the overall stock market has outperformed Treasuries is attributable to large returns earned by relatively few stocks."

Only 4% of all publicly-available and traded stocks outperform the underlying stock market index to which it belongs (or a comparable index) and only 27.5% returned more than the 1-month U.S. Treasury (a very conservative guaranteed investment). It’s also interesting to note that the 4% hasn’t been static — today’s winners weren’t yesterday’s winners. Likewise, tomorrow's winners won't be today's winners. And so… it makes it incredibly difficult to know whether your current stock picks will be the 4% of the future… let alone the 27.5% that beats the guaranteed return of the 1-month U.S. Treasury.

Those aren’t great odds.

This is why a great many investors have decided to purchase index funds or other broadly-diversified investments, in the hopes of capturing the minority of “winners,” wherever they may be hiding.

But… is that a winning strategy? Are the net returns of index-based investing commensurate with the necessary risk you take by diversifying? And if so, do those net returns justify the added expense of mutual funds or other vehicles necessary for proper diversification? And, what about taxes?

Let’s move into the details.

Rate Of Return On Stocks vs Bonds Vs Whole Life Insurance

Most stock market forecasting is mystical and not based in reality. Yet, nearly every Internet expert writes or talks about hypothetical or expected returns of various investments based on those various non-objective or mystical forecasting methods. Still, some forecasting methods can be useful as educational aides. For example, while historical performance is in no way predictive of future investment returns, it can potentially serve as a practical example of how investments can perform under various economic conditions. Historical performance numbers of an investment show one possible outcome (of many) of that investment. Because of this, we can know something about both the absolute and relative performance of various investments. Furthermore, if an investor understands why those investments performed the way they did, it can potentially be informative in making future investments, even if the historical data itself is not predictive.

Historical Returns Of The Vanguard Long-Term Treasuries Fund (VUSTX)

The price of VUSTX (price data obtained from Yahoo! Finance) in June 1986 (earliest publicly-available dataset) was $0.98 per share, adjusted for splits and dividends. By October 2022, that share price had risen to $8.43. If an investor had bought shares of VUSTX in 1986, contributing to the fund each month for 432 consecutive months, it would have resulted in a 36 year pretax return of roughly 4.89% (assuming no major changes through the end of the year).

Assuming just the standard deduction for federal taxes, the after-tax value of this investment would be 36.84% lower than the pretax return, netting an after-tax return of 2.83%. If an investor owes state taxes, the net return would be lower.

Historical Returns Of Vanguard Total Bond Market Index Fund (VBMFX)

The price for shares of VBMFX in January 1987 (earliest publicly-available dataset) was $1.59 per share, adjusted for splits and dividends. By October 2022, the price of VBMFX was $9.33 per share. If an investor bought shares from the beginning of 1987 through September 2022, they would have earned a pretax return of 3.66% (again, assuming no major changes through the end of the year).

Assuming the standard deduction for federal taxes, the after-tax value of this investment would be 35.57% lower than the pretax return, netting an after-tax return of 1.60%. If an investor owes state taxes, the net return would be lower.

Historical Returns Of The Vanguard 500 (VFINX)

The price for shares of VFINX in January 1985 (earliest publicly-available dataset) was $8.65 per share, adjusted for splits and dividends. By October 2022, the price of VFINX was $330.25 per share. If an investor dutifully bought shares from the beginning of 1985 through September 2022, they would have earned a pretax return of 9.52% (again, assuming no major changes through the end of the year).

Assuming just the standard deduction for federal taxes, the after-tax value of this investment would be 39.52% lower than the pretax return, netting an after-tax return of 7.51%. If an investor owes state taxes, the net return would be lower.

Historical Returns Of The American Funds Investment Company of America (AIVSX)

On May 17, 2012, Dave Ramsey posted the following to his Twitter account:

I own a mutual fund with a 11.98% average return since 1934, 13.4% average over the last three years. Is your investment adviser too STUPID to find this?

Ramsey is likely referring to The American Funds Investment Company of America (AIVSX), which is the much-respected managed mutual fund which has been in existence since 1934. This mythical fund is said to have delivered outsized performance to investors over long periods of time. Even Morningstar lists the return since inception as 12.03%. But, the myth is just that. For every fairy tale of stellar performance, there’s reality.

Looking closely at this fund’s share price change over time, adjusted for splits and dividends, reveals its Jekyll and Hyde persona.

In January 1986 (which is as far back as Yahoo! Finance data goes), the price of AIVSX was $2.04. By October 2022, the share price had risen to $38.67. If an investor made regular monthly share purchases of AIVSX, they would have earned a pretax return of 8.18%. It may be true that the return since inception is higher, but... no investor alive today has been investing in AIVSX since its inception.

Assuming just the standard deduction for federal taxes, the after-tax value of this investment would be 39% lower than the pretax return, netting an after-tax return of 6.51%. If an investor owes state taxes, the net return would be lower.

Managed funds, like The Investment Company of America, have sustained many losing months throughout the years, and even losing years. In addition to market losses, AIVSX charges hefty fees for investment management, effectively compounding market losses when they occur.

Historical Returns Of Dividend-Paying Whole Life Insurance

MassMutual (among others) have published the long-term return on dividend-paying (participating) whole life insurance. The net return on a participating whole life policy varies with the age of the policyholder, when the policy was first issued, the insured's risk rating, and the type of whole life (paid to age 100, limited pay, blended whole life, etc). Still, there is a remarkable consistency across blocks of business. 

For example, a 35 year-old female, non-smoker, who purchased a whole life policy in 1980, paying a premium of $4,077.50, and held the policy to 2022, earned a net compound annual return on cash value of 5.77%, and a compound return on death benefit of 6.61%. Total dividends paid to the policyholder were 59% higher than originally illustrated.

In another example, a 45 year-old male, non-smoker, has paid premiums of $5,910 since 1980. Held until 2022, he earned a total net compound annual return of 4.70% on cash values and a net compound return of 5.33% on death benefit. Total dividends paid to the policyholder were 69% higher than originally illustrated.

Another male, aged 50, non-smoker, paid premiums of $14,445 from 1980 to 1990, then stopped. He earned a total net compound annual return of 5.76% on cash value and 6.03% on death benefit. Total dividends paid to the policyholder were 79% higher than originally illustrated.

A Summary Of Historical Returns

In this analysis, it's clear that dividend-paying whole life insurance is highly competitive against bond-based investments, in spite of the fact that whole life insurance is not classified as an investment. It's also somewhat competitive against equity-based investments on an after-tax basis. Moreover, today's blended whole life insurance options (a blend of term insurance and whole life insurance) should be even more competitive than the whole life products available in 1980. On a pretax basis, equity investments appear to be the clear winner, though taxes will reduce the net gains substantially, even if systematic withdrawals are taken from a pretax retirement account over time.

The primary difference between whole life insurance and other assets is the risk taken to achieve the expected return. While other assets have varying degrees of risk associated with them, whole life insurance has no risk on a guaranteed basis, and limited risk on the non-guaranteed dividend side (future dividends are not guaranteed, but earned and reinvested dividends are). Thus, in retrospect, the returns of dividend-paying whole life insurance are, in essence, risk-free.

Factors That Affect Investment Returns

There are many, many, things that can positively or negatively affect your investment return. But, the major factors are:

• Taxability of the contribution (i.e. is the contribution to the investment made pretax or after-tax?)
• Taxability of the investment (i.e. is the investment taxable or are taxes on gains deferred or eliminated altogether?)
• Tax rate of the investment (i.e. what tax rate is applied to the investment gain?)
• Systematic contribution or dollar-cost averaging (i.e. do you invest monthly, over long periods of time vs one time per year?)
• Investment fees
• The return of the investment itself

Most of these factors reduce investment returns and make it more difficult to figure out how much money you’re actually earning or whether the investment is any good.

The Probability Of Earning A Specific Rate Of Return From Equity-Based Investments

Charles P. Jones, professor of finance, and Jack W. Wilson, professor of business management, who both teach at North Carolina State University in Raleigh (right in my back yard, imagine that) have compiled reams of data to study the probabilities of earning various rates of return.

Their findings are published in the The Journal of Portfolio Management, Vol. 22, No. 1, Fall 1995. Also, keep in mind these probabilities were calculated based on the market as a whole and not individual stock selection. It assumes an investor can buy all the stocks in a stock market and perfectly mirror an index——something most investors cannot do, but nonetheless can come close with index funds. Their assumptions also do not factor in the drag on performance created by systematic contributions over time, investment management fees, and taxes.

Jones and Wilson looked at two different time periods, between 1871-1993 and 1926-1993. Using this data, they discovered the probability of earning any given rate of return varied dramatically according to the rate of return itself and also the length of time an investor holds onto his or her investment.

Here’s what they found:

The probability of earning a 15% compound annual return is low… almost impossible, especially over the long-term. For example, the probability of earning a compound annual return of 15% over 20 years was 15.19%. Over 30 years, the probability drops to 10.39%. Over 40 years, the probability is 7.29%.

The probability of sustaining such a high rate of return over long periods of time is very, very low.

But, what about more “conservative” rates of return?

Probability Of Various Rates Of Return

This research assumes a normal distribution of returns and also inherently assumes certain economic conditions which existed in the past. These economic conditions may or may not exist in the future.

Still, as you can see from the study, the probability of earning 10% or 12% returns over the long-term is low. If you adjust for investment fees (even low fees) and taxes, the drag created by systematic contributions to savings or dollar-cost averaging, your probability is going to drop significantly in every return range. And… the data collected from Vanguard, Morningstar, and Fidelity seems to follow the predictions made 25 years ago by Jones and Wilson, which is really very incredible. Indeed, most investors are earning somewhere between 4% and 6%, just as you would expect them to based on the research. Some are earning more. Some, less.

Bottom line: The higher the expected return, the lower your odds of achieving that return. This is why smart investors who take a lot of equity risk also hedge their investments with low risk investments and life insurance products. And, conservative investors who expect to earn less than 5%-6% from investments are likely going to be better off buying high cash value whole life insurance.

Legitimate Outliers And You

The question, for most investors, is not, "what's the best investment I can make?" Rather, it's more along the lines of, "how much risk can I afford to take with my savings?"

Some investors already have all the money they will ever need stashed somewhere safe. Those investors can afford to take a lot of risk. Others have barely enough money saved up for an emergency. Those investors cannot afford to take much (if any) real risks with their savings. Still other investors are somewhere in the middle. They can afford to take some risks with their savings, but they can't afford to risk it all. 

This is the primary decision in front of you. Once you figure that out, you can accurately answer the question of what investment(s) is "the best" for you.

Everyone knows Warren Buffett is a better-than-average investor. Odds are, you're not him. This, of course, doesn’t change the probability of achieving any given investment return. So, for example, no matter which investor we’re talking about, there is — statistically speaking — only a 30% probability of achieving a 12% investment return over the long-term. You could theoretically fall into that 30% probability. But, the odds are against you. If you like investing against the odds, fine. But, don't willfully blind yourself to them.

So, knowing this, if you’re an outlier, you already know the factors which would make it more probable that you would be in the minority of individuals who can consistently and reliably earn stellar double-digit investment returns. If you know of no such factors, however, you can safely assume you are not one of those skillful investors.

Invest accordingly.