The Truth About Investment Returns
Do people really get rich by investing money?
My tl;dr answer is… yes.
The longer, more nuanced, answer is: yes, sometimes, but… it’s not nearly as easy as the Internet makes it sound. Most people are confused about how much money they’re really making in their investments, what they should expect in the future, and how to project future rates of return.
This is, of course, not good. Knowing your true investment return helps you figure out how much money you should be saving to meet your current and future savings goals. So… if you don’t understand how much you’re likely to earn now and into the future, you really don’t know how much you should be saving.
And, that’s why this section exists — to help you better understand how investment returns work, how to calculate them, and what kind of expectations you should set for yourself over the long-term.
Let’s dive in…
Why Is This Important?
Why should you care about how investing (and investment return calculations) works?
The tl;dr version:
- Most people who are saving and investing are not saving enough because they have a false belief about how much they are earning on their investments. The latest research suggests most investors don’t earn a 12% return on their savings… or even an 8% return. Instead, they’re earning between 4% and 6% before adjusting for income and capital gains taxes.
- Fees, taxes, cost of pure insurance (i.e. term insurance), and making systematic contributions (i.e. dollar-cost averaging and making regular contributions to your savings) all have a negative impact on the long-term rate of return on your savings. Knowing how these factors affect your investments and savings allows you to make better long-term plans for you and your family or business.
- Protecting yourself against unscrupulous or ignorant investment advisors, insurance agents, and financial planners who tout unrealistic investment returns can help improve your odds of meeting your future savings and investment goals.
Basic Investment Types
Some Basic Investments You’ll Run Into
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 influence the direction of management and who occasionally shows up to collect profit-sharing checks.
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 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.
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
- 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.
Market Returns: Do Stocks Outperform Guaranteed Investments?
Stocks For The Long-Term?
A great majority of people equate “investing” with stocks or stock-based mutual funds.
And… why not?
It seems almost intuitive that stocks would outperform more conservative investments or assets. After all, why take the extra risk if the stock investment won’t earn more than a guaranteed return from a bank CD, U.S. Treasury, life insurance, or fixed annuity?
But… is it fair to assume all (or even most) stocks will outperform other — less risky — 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 that:
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, which is a very conservative guaranteed investment.
Why, then, do so many financial experts and the media claim that stocks outperform other asset classes over the long-term?
Because… they do.
In aggregate — meaning, if you took all the stocks available for sale and measured them against other assets — stocks do outperform. This is due to the fact that roughly 4% of the total stocks available for sale in the financial markets carry 96% of the “losers” or mediocre companies.
Said another way, it’s the minority that carries the whole… the 4% which are responsible for all the net gain of all stock markets, as a whole.
If that sounds like an incredibly small percentage, it’s because it is.
It’s also interesting to note that the 4% hasn’t been static — today’s winners weren’t necessarily yesterday’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.
First, a discussion of how returns are calculated.
Average Rate Of Return vs Compound Annual Growth Rate (CAGR) vs Internal Rate Of Return (IRR)
How Your Investment Returns Are Calculated
Let’s rap about how investment returns are calculated.
Seems like a pretty straightforward question, doesn’t it?
“What’s my rate of return… 12%?”
Turns out, it’s a lot more complicated than that.
The financial industry shows investment returns one of three ways:
- Average annual return
- Time-weighted annualized return (compound growth rate), or
- Dollar-weighted annualized return (compound annual growth rate)
Mutual fund salesman, stock brokers, insurance brokers, and Certified Financial Planners sometimes show their clients an “average rate of return” when selling investment ideas.
For example, Morningstar (which describes itself as “a leading provider of independent investment research in North America, Europe, Australia, and Asia”, and is considered by many to be a major source of objective investment research and analysis) publishes total return data on a variety of mutual funds, but also discloses that “Returns are simple averages.” Meaning, Morningstar provides reams of investment return data to financial advisors, individual investors, asset managers, retirement plan providers, and also institutional investors which is based on a simple averaging of numbers (Morningstar also, however, calculates dollar-weighted or investor return. More on that later).
Simple averaging is a slick way to juice investment returns on paper.
Here’s how it works:
If you invest $100 and make 25% in the first year, then you lose 25% in the second year, how much did you average?
Well, if we’re talking about a simple average return, you made 0%, right (+25 – 25 = 0 / 2 = 0)? Not great but at least you didn’t lose money… right? …. RIGHT?
Let’s see the replay in slow-motion: You made 25% in the first year ($100 +25% = $125). Alright, you’re on fire. Now, in the second year, you had a reversal of fortune ($125 – 25% = $93.75).
You actually lost money. But wait… your advisor said you had an average return of 0%.
Let’s look at another example.
Suppose you invest $1,000 and it averages 12% per year. I like 12% because it’s what all the gewroos on the T.V. and radio use:
It can look like this:
|Year||Starting Dollar Amount||Earnings Rate||Ending Dollar Amount|
Pretty simple, right? If you earn 12% each and every year, your average is obviously 12%.
But, it’s pretty rare for any investment to give you such easy returns.
Usually, returns in each year fluctuate… sometimes dramatically.
|Year||Starting Dollar Amount||Earnings Rate||Ending Dollar Amount|
This, too, shows an average rate of return of 12%. If you add all the return percentages together, and divide by the total number of years you invested (5), then you get 12% (20 + 4 – 10 + 24 + 22 = 60 / 5 = 12%).
And yet, you end up with a very different ending dollar amount. That’s because, while the average return is 12%, the compound return is 11.18%. More on that later.
Let’s try this again:
|Year||Starting Dollar Amount||Earnings Rate||Ending Dollar Amount|
Again, the same 12% average return, with — again — a different ending dollar value than before. A 12% average, but a compound return of only 7.91%
In fact, if you do this for the entire history of the S&P500, which is a major stock market index, you’ll find the average rate of return of the market since 1930 has been 11.69% — about 12% per year. So… our T.V. gewroo is correct.
However, the compound return… the actual growth of the market (the rate at which it compounded) has only been 9.78% (yes, this includes reinvested dividends).
And, in fact, we can stretch the market data back as far as 1871 (though accuracy becomes a problem when you do this) and the results don’t change much.
But, depending on when you started investing, your actual return might have been 15% or… it might have been 4% or… it might have been a negative return.
The difference in investment returns happens for several reasons.
First, there’s the obvious which I just wrote about above. The average return might be positive, even when the compound return is negative… meaning you didn’t actually earn any money.
Secondly, timing is everything. If you started investing just before a market crash or right at the tail end of a bull market, you’re not going to realize that long-term average everyone’s talking about.
Thirdly, systematic investing, or dollar cost averaging, tends to lower returns in most 10, 20, and 30-year investing periods. This is a mathematical quirk that no one can escape. You’re contributing money to investments throughout the year and thus are unable to capture an entire year’s worth of gains. Even if you invested a huge lump sum in January, you’d run into the same problem as you’d have to save up more money for the following year to do the same thing. More on this in a moment.
What’s going on with all this stuff?
Well… when an advisor averages returns, they are using a simple average.
Simple averages do not take into account the compounding of returns. Instead, simple averages give you what’s called an “arithmetic mean.” It’s a dumb way to calculate return averages because it doesn’t correspond to the rate at which money actually grows.
Compounding annual returns, or “annual internal rate of return,” represent a “geometric mean.” And… this is the way you want to calculate your return… always.
The good news is if you know the average return and the standard deviation, and you’re comfortable using a spreadsheet program, you can calculate the approximate compound annual return by using this formula:
Otherwise, use a RATE function in Excel or calculate the compound return by hand. If you have uneven cash inflows (i.e. you contribute different amounts of money to your savings every year), you should use a special IRR (internal rate of return) function in Excel.
NOTE: If you’re a moderate to expert-level Excel user and you want to try calculating this yourself, do not use XIRR in Excel. It contains a known bug which results in an incorrect calculation. Instead, calculate cumulative IRR year by year (i.e. the cumulative IRR, which adds in contributions from all previous time periods up to the current period), which will guarantee you get the correct result… like this:
Annualized, Compound, And Internal Rate Of Return
In this guide, I’ll try to stick to Annualized, Compound Annual Growth Rate (CAGR), or Internal Rate Of Return (IRR). All of these mean approximately the same thing within the context I’ll be explaining them in.
Both annualized and CAGR is literally the smoothed-out growth rate that takes you from your initial or starting dollar amount to the ending dollar amount, assuming your investment has been compounding for all the years you’re measuring.
Compound annual growth removes the volatility you would actually experience in an investment and assumes your investment grew at a steady, constant, rate.
For example, if you start with $1,000 and end up with $1,463 after 5 years, you may have had wild fluctuations in all years, but… you know that the compound annual growth rate is 7.91% (the exact compound annual rate is actually 7.9068128194717%, but I rounded it for simplicity’s sake). In other words, if you took $1,000 and then added 7.91% interest, then added another 7.91% interest on top of that (compounding the return), and kept doing that for 5 years, you’d end up with $1,463 after 5 years.
In real life, you might have made 3% in one year, 10% in another, and lost 2% in another, and so on… the compound annual growth rate calculation smooths out all this volatility so you can see what your real average growth rate per year was.
You can verify this easily in any online savings calculator that allows you to input a dollar amount you want to save and an annual compounding interest rate.
The resulting dollar amount would be what you would see in your savings or investment account at the end of 5 years, assuming you paid no taxes or investment fees.
Why is this important? Because it lets you stand back and see the “big picture” of how well your investment did… after the fact. It’s an average return but it’s a geometric average (mean) and not a simple or arithmetic average. You can use this information to judge whether your investment performed well or whether it failed to live up to your expectations.
Internal Rate of Return (IRR) is very similar to the CAGR. IRR is literally the interest rate at which the net present value (NPV) of all cash inflows and outflows from an investment equal zero.
In plain English, in this context, it is the interest or earnings rate your investment had to grow each and every year to equal the ending dollar amount you currently have.
Like CAGR, if you start with $1,000 and end up with $1,463, the IRR will tell you that your savings grew at 7.91% per year. Again, this smooths out the volatility in returns you actually experienced, but in doing so, it gives you a very clear picture of what your actual compound annual growth or compound average return was over the years.
Why use IRR instead of CAGR?
With CAGR, you have to assume you invest one dollar amount, one time, and then let it grow over a specific number of years. Most people don’t invest this way.
IRR allows you to add and subtract money from your investment so you can see the impact adding or withdrawing money from your investment has on your savings and investment return.
This is how most people invest or save money, myself included. You save $200 per month or $1,000 per month or whatever. And, when you retire, you withdraw $20,000 per year or $100,000 per year or whatever.
IRR will tell you the compound annual return you’re getting on your savings, adjusting for the fact that all this money is sloshing around in and out of your savings at different times.
And, again… knowing your IRR (and even an expected or projected IRR) helps you make an educated guess as to how much money you should be saving to hit your current and future savings goals… especially if you know how far away from the average return each year’s actual return is (i.e. standard deviation).
Here’s a simple explanation of how standard deviation works:
Standard deviation has lots of uses in finance, like… calculating the probability of you getting a specific return on your savings.
I bet you’d like to know that little bit of info, wouldn’t ya? We’ll get to it in a moment.
Many advisors who calculate compound annual returns for their clients choose to show them time-weighted returns.
These returns represent the returns the advisor is earning with your money. But, it does not represent the return you will experience on your own money. Time-weighted returns explicitly remove the effect of adding and subtracting money from an investment portfolio.
And, when you do that, you can never know (not in a million years) how well you’re doing in your own investments — you can never know the rate of return on money you’re adding to your savings every month (or year) because… it is explicitly removed from the calculation.
The rationale here is that the investment advisor or financial planner can’t possibly predict how much money you’ll put into your investment account or how much you’ll withdraw over the years so… he or she won’t tell you (or anyone else) what your actual return on your money is.
An advisor (understandably) doesn’t want to be responsible for things outside their control. And, you adding or withdrawing money from the investment portfolio is outside of the advisor’s control.
Instead, you’ll know the return of the mutual fund itself or the return your advisor is earning with your money.
This return assumes a compound annual growth rate, putting in a one-time deposit and measuring it each year (usually on January 1). Sometimes, you’ll see or hear this referred to as the “trailing return.”
If you want to know the return on your own savings, time-weighted returns are a rather useless metric. But, these are almost always the only returns you will ever get from a mutual fund company or an investment advisor unless… you specifically ask for a dollar-weighted calculation.
Generally, dollar-weighted return is very similar to the IRR (internal rate of return). In many cases, it is exactly the same. It is the rate of return calculated for each period based on the amount of money in your investment portfolio at the beginning of the period. It takes into account money being added (or removed) from your investment portfolio and thus better reflects what you — the investor — have earned on your investment portfolio.
If you contribute money to your savings and investments each month, or year, it calculates the return at the beginning of each month or year, respectively.
But, if you assume you make contributions at the end of a period (i.e. the end of the month), the IRR will still reflect the compound annual return for the year (but it will technically show it as “beginning of year” even though the actual and correct calculated contributions and interest earnings are spread out throughout the year).
Either way, when figuring out the return on your savings, this is the return calculation you want to use, always.
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.
Because finance is already a pretty difficult topic, a lot of folks simply leave it to the professionals to tell them what’s what. This is a huge mistake. There are plenty of honest and forthright financial professionals in the industry.
But, there are some shysters, too.
And, even among the honest folks, there is a healthy amount of ignorance about how interest rates and investment returns work and how they’re calculated.
As an investor, knowing this is important, because it informs your investment strategy. For example, if you know the most you’ll probably ever make is 5% per year on your investments, then you know you’ll need to save more money than if your “best guess” investment return was 10%.
If you’re banking on a 10% return, and you only make 6% or 7%, you’re in trouble — you won’t save enough money to generate the income you need.
Life will suck. Game over.
Effect Of Fees On Savings Growth
Nothing kills a great savings plan quite like fees.
John Bogle, the man who started Vanguard, has famously stated:
Do you really want to invest in a system where you put up 100% of the capital and as the mutual fund shareholder you take 100% of the risk, and you get 30% of the return?
What does he mean by this? Consider if you made a 7% return on your investments, but paid 2.5% in cumulative fees to your financial advisor and mutual fund.
Over your entire lifetime, it can grind away 70% of your total savings.
Each year, that 2.5% fee is money you pay which does not earn interest and thus does not compound. Each year your savings grows, that 2.5% fee is taken off the total balance of your savings, further reducing the amount of money that compounds. And, because your earnings rate compounds each year, that fee effectively compounds against your savings… each year.
So what? How much can that silly little fee really cost?
Using the example, above, let’s say you manage to earn 7%, but your fee is 2.5%. What is your net return on investment?
Here’s how you calculate it:
Net return = Gross return – Fee
So, what you would do in this example is grow your savings by 7%, then subtract a 2.5% fee and run a rate calculation in Excel or do it by hand.
Let’s say you invest $1,000. A 7% growth on that in one year leaves you with $1,070. Then, subtract a fee of 2.5% ($26.75), and you’re left with $1,043.25.
That means your original investment really only grew from $1,000 to $1,043.25, or a 4.325% return:
(($1,000 / $1,043.25) – 1) = 0.04325 = 4.325%
The compounding nature of fees cost you 2.675% on a 2.5% fee.
Now… multiply this over the next 30 years and it’s easy to see why some advisors freak out about investment fees.
They can cost you… a lot.
Effect Of Taxes On Savings Growth
Taxes always have a negative impact on your savings growth because it’s essentially another fee you’re paying… this time, to the government.
For example, let’s say you’re earning a net 5% return on your investment, after fees. And, let’s also assume your tax rate is 12%. What is the net return you earn on your investment?
It’s calculated like this:
After tax return = Investment return * (1 – your tax rate)
In this example, it would be:
0.05 *(1-0.12) = 0.044 = 4.4%
So… your after-tax return would be 4.4%.
If your taxes are higher, it gets worse. In a 22% tax rate, your return would look more like this:
0.05 *(1-0.22) = 0.039 = 3.9%
3.9%… yikes. The taxes cost you 1.1%. Obviously, anything you can do to reduce your taxes is a plus. But, should you reduce them on the front end of your investment (when you’re making contributions to your investment plan) or on the back end (when you’re drawing income)?
In most cases, it makes sense to eliminate taxes on the back end.
A Word On Traditional 401(k) Plans, IRAs, And Other Similar Qualified Retirement Accounts
There is generally no real tax advantage to using a 401(k) as versus a life insurance policy, Roth IRA, Roth 401(k), etc. (blasphemy, I know).
Here is the way to think about it, tax-wise:
If you have $100 to invest, you can do it pretax inside a qualified plan or post-tax in something else.
All other things being equal, you either pay the tax now or later. With a traditional 401(k) your contributions are deducted from your paycheck or payroll and no tax is paid. With an IRA, your contributions are deducted on your tax return. Either way, the effect is the same. You don’t pay tax on your contributions.
Let’s say you choose this route and make a $100 pretax or tax-deductible contribution.
Assuming a 10% tax bracket, how much money can you put in your 401(k)?
Now, assume it doubles. You have $200. Now pay the 10% tax at retirement. You have $180.
Instead, you could pay the tax upfront… $90 ($100 – 10% tax = $90). Then, your investment doubles inside a tax-deferred product or account to… $180.
You end up the same, either way.
The only way it changes is if your tax rate changes. And, most of the time, those changes will not favor the traditional 401(k) or IRA. For example, you’ll presumably be adjusting your income in retirement for inflation (just as you sought inflation-adjusted returns on your savings prior to retirement).
That constantly-increasing income means more and more of your income from the traditional 401(k) or IRA is taxed as it eventually pushes you into a higher tax bracket.
For example, suppose you saved up enough money to withdraw $38,700 as an individual or you and your spouse withdrew $77,400 in income during retirement. And, for now, forget about tax deductions or assume that the income you net in retirement is right at those dollar amounts after adjusting for the standard deduction.
And, let’s say the very next year you need more money because the cost of living increases by 3%.
Since you were just on the edge of the new 12% tax bracket, your 3% increase pushes some of your money into the next higher bracket — 22%. You pay more tax. And… it never stops increasing. Each cost of living increase increases the amount of tax you pay and decreases your net income, effectively reducing your net return on your investments.
Remember, taxes are basically just another fee that eats into your net investment return (Oh noes! Mah gainz!)
This does not happen if you paid the tax upfront and withdraw money tax-free later.
Effect Of Life Insurance On Savings Growth
Cost of insurance always has a negative effect on the growth of your savings. The more you pay in insurance costs, the less money you have to invest.
Usually, people take this to mean they should buy term life insurance and try to minimize the premiums they pay.
It’s a little more nuanced than that, though, because term premiums represent a 100% loss — you typically get nothing back from the insurance company unless you buy a term policy with return of premium or you’re able to sell your term policy to someone else before you die.
Mostly, term policies expire worthless.
However, whole life, and to a lesser extent universal life, have premiums that grow at a guaranteed interest rate, and can also earn more than the guaranteed rate (e.g. dividends in a whole life policy)… which dramatically reduces the net cost of insurance and out of pocket premiums over time.
This interest (plus non-guaranteed dividends) is the time value of money in action. Meaning, the total net cost of insurance in a whole life policy is not as expensive as most people think. This is counterintuitive because the premiums are much higher than for term insurance. This is discussed in much greater detail elsewhere in the guide.
For now, realize that cost of pure insurance insurance in both whole life and term insurance is a drag and represents a 100% loss against your investment gain.
For example, if you have a total of $10,000 per year to save, invest, and insure your life with, and you have to divert $1,000 per year to the cost of insurance, then you can only invest $9,000 per year.
Already, you are suffering a 10% loss on your contributions ($10,000 – 10% = $9,000), which negatively effects the total return on the $10,000 you’re saving each year.
Minimizing those insurance costs over the long-term is key. You must either earn a good rate of interest on your premiums (e.g. in whole life insurance) or lower your term insurance costs.
Effect Of Systematic Contributions Or Dollar Cost Averaging On Savings Growth
Everyone contributes money to their savings or investments on a monthly basis, whether they want to or not. It’s a mathematical quirk that almost no one wants to talk about — no financial advisor, anyway.
This is why calculating IRR on your investments is objectively more accurate than using time-weighted return calculations. Each month, you are adding money, and so that affects your investment returns.
Let’s say an investment earns 12% per year. And, let’s further assume that these returns are distributed roughly equally throughout the year (for now).
That means, each month, your investment earns 1% (1*12 = 12%). Now, you make a contribution to your savings in January.
What happens? When do you make that contribution? At the beginning of the month, before you’ve been paid or at the end of the month like everyone else?
The answer is obvious. You can’t invest money you don’t have.
So, you invest at the end of January. But… this means you miss out on most of the returns in January. Maybe you missed out on all the returns in January.
Next month, you repeat the process. What happens? You contribute money to your savings at the middle or end of February… whenever you get paid, and… January’s contribution earns a full month’s worth of interest or return.
In March, the same thing happens. April — same. For the whole year, your current month’s contribution missed out on the gains in your investment for that month.
Additionally, the year is getting shorter and shorter with each contribution to your savings. January’s contribution earns interest for 11 months. February’s contribution only earns interest for 10 months. March’s contribution to savings earns for 9 months, and so on.
Your last contribution in December misses out on that year’s gains entirely. Merry Christmas!
The good news is, the next year, all those contributions are invested and so earn a full year’s worth of interest and gains. But, new contributions made the second year go through the same process that the first year’s contributions went through.
The same thing happens when you dollar cost average your investment. Suppose you have $10,000 to invest. You spread it out over 7 months. That’s $1,428.57 per month. Obviously, the last $1,428.57 investment you make isn’t earning interest for the full 7 months.
How does this affect your earnings rate or investment return? It reduces it… sometimes dramatically. And… it reduces the amount of money you’re able to accumulate for the future.
For example, suppose your financial advisor, or some self-proclaimed financial gewroo tells you that if you invest $200 per month for 30 years, you’ll end up with $648,702. Let’s forget about investment fees and taxes for a moment.
We’re assuming you put $2,400 into an investment 0n January 1 of each year for the next 30 years. This is how nearly every online financial calculator works and how nearly every financial planner shows savings growth.
It assumes your contribution happens all in January. Is this realistic?
In reality, when you contribute $200 per month, and if you could earn 12% annual return, you would end up with $610,402.66, give or take.
That’s only a difference of $38,300 from the first calculation which assumes you make contributions at the start of the year, but… who’s counting, really?
Again, this is not your fault. It’s simply the way things are.
But… do you see why someone might be willing to show you a higher dollar amount as versus a lower dollar amount?
And… if you’re assuming you’ll have more money than you’ll really have, you won’t need to save as much, which… makes it an easy sale.
High return assumption.
High savings amount.
Less money you have to save.
It’s. So. Easy.
But… let’s suppose you do make your contributions at the beginning of the year. Let’s suppose you have $2,400 laying around somewhere. Doesn’t this solve the problem?
Nope. If you have $2,400 right now to invest, and you invest it, what do you have left? Nothing. What do you have to do? Save it up again over the next 12 months. Now you’re right back to where you were before…
Statistics: How Well Does The Average Investor Do?
So… Now What?
According to the Internet, everyone is earning 8% returns on their investments. Or… if you happen to be in that special Interweb zone… you’re earning 12% returns every year.
Let’s get real.
There are some very good studies out there showing what investors actually earn and what they have been earning for many, many, years.
We also have very good and robust data on current savings balances in 401(k) and IRA plans. So, when it comes to investment returns and your potential as an average (or even above-average) investor, it’s not a mystery.
We know what your potential for future investment returns is.
According to, Mind the Gap: Global Investor Returns Show the Costs of Bad Timing Around the World, published by Morningstar in 2017, there exists (unbeknownst to some) robust data showing the average diversified equity (stock) fund returned about 5.13% between 2006 – 2016. During that same time period, investors averaged 4.36% — a 0.77% difference.
The article cites poor investor performance as the main reason for this disparity between market return and investor return.
I suspect a lot of this disparity is actually attributable to the natural drag created by systematic contributions or dollar-cost averaging (discussed above) and some of it is possibly poor investor behavior (buying and selling at the wrong time or trying to “get revenge” on the market for previous losses).
The Vanguard Reality Distortion Field
A longer-term analysis of investor returns was done by Dan Wiener. Wiener is someone few people have ever heard of, outside of astute Vanguard investors.
Next to perhaps John Bogle (the founder of Vanguard), Wiener is the most knowledgable person about Vanguard, specifically, and index fund investing, generally.
He’s a former reporter on the mutual fund industry, an independent investment advisor, and the editor of The Independent Adviser for Vanguard Investors, a newsletter that covers Vanguard and its funds for the benefit of its investors.
Why is this significant?
Because… Vanguard made a name for itself by selling low-cost index funds which track the performance of a broad market index, rather than actively managing investments for clients. Its major selling point is its low fund management cost (they charge 84% less than the industry average) and its ability to outperform most actively managed mutual funds.
It’s difficult to find anyone critical of Vanguard, and most financial advisors, finance bloggers, and self-proclaimed investing experts agree that Vanguard sets the standard for what a mutual fund company ought to be.
Surely, if Vanguard set the standard for performance and low fees in the industry, then its investors should be making mad money, yes?
Wiener tracks the performance of Vanguard investors over time, and he knows something most investors — even most Vanguard investors — do not.
His data, which spans 27 years, shows what the average Vanguard index fund investor has earned since 1991 (brackets indicate negative returns):
|Year #||Year||Annual Return (%)|
It looks impressive, yes?
These are not the index fund returns but rather what investors themselves have actually earned over the years.
There are so many years where Vanguard investors earned double-digit returns that you may guess the actual growth rate must be a double-digit return.
But… it’s not.
An investor who invested $10,000 in 1991 and held it for the next 27 years made a compound annual return of just 7.64% before taxes. An investor with a 10% tax rate may have only earned 6.88%. An investor with a 25% tax rate may have only earned 5.73%.
But… most investors don’t invest one time. They make a series of contributions over time.
An investor contributing to his or her savings each month would realize a true internal rate of return (IRR — the compound annual return) somewhere in the neighborhood of 6.75%, again… before taxes. An investor with a 10% tax rate may have only earned 6.08%. An investor with a 25% tax rate might have earned 5.06%.
Keep in mind, these are averages. Undoubtedly, some investors earn more and some earn less. But, they all take on significant investment risk to achieve these returns. More on that in a moment.
Something to think about is the fact that these returns do not include the cost of term life insurance.
Investors often use term insurance as an alternative to buying whole life insurance (the so-called “buy term and invest the difference” strategy). These investors must divert investable dollars to term insurance, which reduces the amount they’re able to save over the long-term. It also further reduces the effective return on their total investment in the “buy term and invest the difference” strategy.
Of course, this is only relevant if you are directly comparing investing to buying whole life insurance.
Back to index fund investing… It was so clear, and so obvious, that Vanguard investors were not earning anywhere near the stock market’s long-term average, that Wiener commented in 2007:
Vanguard wants you to ‘believe’ in indexing. Your faith in indexing is the cornerstone of their business. But it’s a lie. And your trust could cost you…plenty!. … Indexing doesn’t work for you. It works for them. The big famous Index funds at Vanguard have chronically underperformed over the last few years, exposing conservative investors to the worst risks of bear markets. But Vanguard knows investors who plunk money into an index become “passive.” Their money goes “dead.” And Vanguard never has to worry about these clients getting antsy. Indexing is a great business—but it’s a lousy investment!
There’s nothing wrong, per se, with what Vanguard is doing. It’s simply running a profitable business. In fact, Vanguard is a rarity in the financial industry in that it is mutually-owned. Meaning, there are no outside shareholders.
Vanguard is wholly-owned by its mutual funds which are, in turn, owned by its investors. Hypothetically, this should align the interests of the company with the interests of its investors.
That its investors earn somewhere between 4% and 6%, on average, after taxes should not give you the impression that something fishy is going on.
It should give you a frame of reference and set your expectations for what’s achievable with a relatively “hands off” approach to investing.
And, Vanguard is not the only one reporting these kinds of results.
A study by Fidelity, one of the largest retirement plan providers in America, found that the number of 401(k) millionaires in the U.S. had doubled back in 2014, but… the average investment return of those investors was just 4.8%.
The driving factor behind their new millionaire status was not investment gain but rather contributions — these people simply saved more money than everyone else.
To drive the point home, Fidelity looked at the average return on investment for all its investors (they call it “personal rate of return”).
They found the 1-year personal rate of return of the average investor with a Fidelity retirement account was 19.5%. That might sound really impressive. It sounds really impressive to me, and this one reason why people “buy the dream” of a 401(k) and IRA plan.
But… long-term returns are what really count here. And, Fidelity found the 10-year compound annual return for Fidelity investors averaged just 5.8%, before tax. An individual paying a 10% tax rate may have only earned 5.22%. Someone paying a 25% tax rate might have only earned 4.35%.
As time goes on, returns become muted by fees, natural gyrations of the stock market, the effect of dollar-cost averaging and systematic contributions, and taxes, among other things.
Fidelity also revealed that:
The average 401(k) balance rose to $104,300, 13 percent higher than Q4 2016. The average IRA balance climbed to $106,000, which is also a 13 percent year-over-year increase.
In addition, long-term 401(k) savers saw significant increases to their average account balance. For workers who have been contributing to their 401(k) for 10 consecutive years, the average 401(k) account balance increased to $286,700, up from $233,900 a year earlier. For individuals who have been in their 401(k) plan for 15-straight years, the average balance rose to $387,100, up from $318,500 in Q4 2016.
This is based on data from 22,400 retirement plans and 15.3 million participants. So… not a small sample size.
Fidelity found the average employee contribution to retirement plans was 7.9%. In other words, individuals are saving roughly 7.9% of their income into retirement plans, which translates into an average annual contribution rate of $6,570 per individual. Obviously some folks are contributing a lot more and some, a lot less.
But wait! There’s more! … seems people have at least 50%, and in some cases more than 75%, of their money in equities (stocks). A growing number of people use new-fangled target-date funds and yet… investment returns are not what you might expect them to be, given the risk investors are taking.
Maybe Fidelity’s Hugemongous Sample Size Consists Of People Who Don’t Save Much Compared To The General Population?
Data from the U.S. Bureau Of Economic Analysis shows that savings rates peaked in May of 1975 at 17 percent of income. Since that time, savings rates have trended downward. Today, the average savings rate in America is just 2.8% of income. This means the “average person” is saving just 2.8% of his or her income.
So… it appears that people who have retirement plans through Fidelity are actually above-average savers.
For folks who do save, it seems incredible that investment returns could be so low, especially considering the mainstream media and many financial bloggers, investment advisors, insurance agents, and self-proclaimed Internet experts keep talking about those elusive 8% returns.
If people are doing so well, so easily, then there should be some evidence of this fact, but… there isn’t.
The Dave Ramsey Factor: What About Those 12% Returns?
What’s up, Dave Ramsey fans?
The counterpoint to the hypothesis of low investment returns is what I shall call “The Dave Ramsey Factor.” Dave Ramsey is the Christian (faith-based) money advisor-slash-T.V. personality-slash-radio personality.
One of his favorite topics is investing… and he has forever-advocated an all-equity mutual fund approach to investing because he doesn’t believe in investing in bonds, mortgages, income-producing assets, or other debt-based instruments (because he says the Bible says debt is bad).
Specifically, he recommends a 4-fund approach: growth, growth and income, aggressive growth, and international.
Why does he (and a growing number of investment advisors) recommend this strategy. Because, hypothetically, it should produce the highest long-term return of any other investment strategy. You’re basically going “full tilt” into the equity markets with an eye towards growth, growth, growth.
Anyway, one of his beliefs, which he enthusiastically passes on to his listeners and followers, is the idea that you can earn 12% per year (or more) on your investments… so long as you follow his advice.
On his website, he cites data which shows the historical (simple) average of the stock market is about 12%. As you know, there is a huge difference between a simple average and the compound annual growth rate.
When people ask him very pointed questions about this, he usually goes on some sort of a rant about how awesome he is and… how crappy the skeptic is for questioning his wisdom. He usually won’t mention which specific mutual funds he’s referring to when he says you can earn 12%.
On his website, it says,
Will your investments make that much (12%)? Maybe. Maybe more.
How can he be so sure?
And, which mutual funds does he recommend?
If you do enough digging, you will find mutual funds which seem to have a long-term average of 12%. One such fund, and one that Ramsey has hinted at in the past, is American Funds Investment Company Of America® (AIVSX) — Class A shares, of course.
This fund was started, if you can believe it, in 1934 and is still making money for investors.
How much money?
I pulled the entire history of AIVSX and… here’s what I discovered…
The Investment Company Of America®: The Real Return Of A Hypothetical Investor
Here is the full history of AIVSX, with each year’s annual return, starting in 1934. The returns have been adjusted for the sales load charged for investing in this fund, per the data provided by American Funds:
|Year #||Year||Annual Return (%)|
Average wage for an American in 1934 was $1,600.00… per year. Suppose our hypothetical investor sacrificed almost everything for one year and saved $1,000, one time.
That lump-sum investment in 1934 would grow to $14,829,775 by the end of 2017, producing a 12.11% gross compound annual return. This assumes our investor never paid taxes for any of these years (which is impossible, but hey…). This does seem to show that if someone held their investment for 84 consecutive years, they did alright.
However, do most people invest this way?
Most people dollar-cost average or invest money over very long periods of time. Suppose our hypothetical investor set aside just $100 per month, every month, for the full 84 years.
This individual would have made a compound annual return of 11.61%, before taxes.
OK, so far so good. That’s a decent return for a non-professional.
But… figure that a person who is 70 years old today would have been 14 when they started. And, a person who started investing even at the young age of 20 — in 1934 — would likely be dead today.
Most of this mutual fund’s stellar returns came in the first 12 years of the fund, from 1934 through the end of 1945, with the second year posting an unbelievable 83.08% return for the year.
From 1945 to the mid 1980s, the fund did well against its peers, but the growth rate had definitely slowed down (which is common for a popular fund that grows very large).
For the last 30 years, which covers the period most serious savers and investors were alive, investors have enjoyed a true compound annual growth rate of about 9.52%, before taxes.
An investor paying a 10% tax rate received a net return of 8.56%, assuming he received a tax deferral for the entire time (401(k) plans were just starting back then, and only about half of large corporations considered offering them to employees). An investor paying a 25% tax rate received 7.14% return on his savings (again, assuming ideal conditions where the employee had access to both a 401(k) and American Funds). An investor paying a higher tax rate — say 30% or so — received just 6.66%.
That’s still pretty good, but nowhere near 12%.
And — again — this assumes an ideal scenario of 30 full years of tax deferral (which most people did not have), no inflation on retirement income withdrawals (unlikely unless inflation stops completely), and our hypothetical investor never needing any of that money for 30 years to fix his car, or buy herself a new wedding dress, or make a down payment on a home, or buy a new water heater, or take her dog to the emergency vet at 4AM, or pay for new braces, or meet any deductibles on any insurance policies — ever.
One final thing to note here: you cannot mention investing in this context without also mentioning term life insurance. Dave Ramsey is a big believer in term insurance. Had our hypothetical investor purchased term life insurance for 30 years, starting in 1987-88, the return on a term plus this mutual fund strategy would have been about 6.31% – 7.56%. You could shift the years back and forth by 5-10 years, and it wouldn’t make much of a difference.
Again, not bad, but also nowhere near 12%.
Another favorite of Ramsey’s is American Funds The Growth Fund of America® (AGTHX). This fund started in 1973, with a slightly higher average annual return but also larger losses in key years like 1974, 2001, 2002, and 2008.
As you might expect, looking at the data over the long-term shows that there is no such thing as a free lunch. Investors had to work very hard for their returns and many investors who have been investing for the past 30-40 years have not received anything approaching what Ramsey argues is commonplace.
There’s nothing wrong with aggressive growth mutual funds, but there is also nothing magical about them. They reach for the stars, but there is never any guarantee they’ll get there.
What Is The Probability Of Earning A Specific Rate Of Return On Your Savings?
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 a the market as a whole and not individual stock selection. Meaning, 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?
**Annual return is on the left, and the probability of achieving that return is listed on the right under various time periods (i.e. 10 years, 20 years, etc.)
|Annual Return||10 Yrs||20 Yrs||30 Yrs||40 Yrs|
Again, these probabilities do not account for the payment of taxes or investment management fees (including transaction fees), as both are highly variable across different time periods and income ranges. It is just the probability of raw return from the market as a whole.
Also, one important thing to consider is that there is always room for error when predicting the future. 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. And, for all but the luckiest of investors, not even “superstar” mutual funds from American Funds could escape the mean reversion gravity-well.
Is that cool, or what?
So… What Should You Do?
At this point, I have either shattered your dreams or validated your worst fears.
My intention was to do neither of those things. Rather, I want to emphasize the fact that investing is possible for everyone. Everyone. However, it is also very difficult to earn a double-digit (or near double-digit) return without a lot of hard work. And, even with a lot of hard work, some professional investors still struggle.
But, again, that doesn’t mean you should not invest and it doesn’t mean you cannot succeed.
What it means is investing is a skill and, like any skill, you must spend a significant amount of time practicing and learning it if you want any chance at proficiency. Even with years of experience and study, there is a chance you fail to become a good investor. Like any other skill, success is not guaranteed.
So… think about the issue rationally.
For example, if you set your goal rate of return at 10%, realize the probability of you hitting this goal is very low. Are you really good enough to beat the average? Most people are, statistically, not good enough.
What About The Outliers?
On the Internet, everyone is an outlier. If you wander into any investment forum, it seems like everyone is beating Warren Buffett with one hand tied behind their back.
Does this make any sense? What explains the seemingly endless numbers of double-digit returns touted on Internet forums, investment newsletter writers, and radio and T.V. personalities?
You can’t have outliers without liars… No. Wait.
Anyway, I don’t want to be the one who takes your Internet virginity, but there are people on the Internet who lie. And, those liars are very clever in their deceitful mechanizations, often employing psychological manipulations and intellectual gimmicks.
Some of these people are very famous radio and T.V. personalities and financial “gurus.” They may engage in tactics like browbeating critics and even fans of their show or subscribers. They will usually (at some point) engage in some type of personal attack in response to honest criticism.
For example, a famous financial guru, who has been proven wrong about his investing (and other) “theories” on numerous occasions, justifies his outrageous claims by arguing he’s motivating people to save more money. Meanwhile, he sells a variety of books and courses and even monthly subscription services which siphon money out of his followers’ checking accounts on the regular. That’s literally the opposite of helping people save more money.
Of course, it doesn’t mean he doesn’t help people save at least some money.
But… his style of argumentation is the classic “ends justify dishonest means” tactic where a guru will (eventually) admit to his or her faulty reasoning, but excuses himself on the grounds that he’s motivating his audience to do something good. The fallacy here is that it’s possible to do good and help people while simultaneously using intellectually dishonest means. The obvious truth of the matter is it’s quite simply not possible to do anything good by being dishonest.
But, dishonesty isn’t limited to financial gurus. Personal finance bloggers, finance journalist, and even Certified Financial Planners have been caught engaging in dishonest and evasive behavior, up to and including, falsifying and publishing misleading reports of investment portfolio returns.
Some people are honestly mistaken about what they are earning on their investment portfolio, either because they were lied to by a trusted financial advisor or they themselves do not know how to accurately calculate their own investment portfolio returns.
There’s nothing wrong with not knowing how to do something, especially in finance. Some of this stuff is difficult. But, it is an error nonetheless.
Selective Focus and Other Cognitive Biases
Sometimes, people are biased toward or against something and either knowingly bias themselves or evade the issue altogether.
For example, a phenomenon called “confabulation” helps to explain why some people make up fantastical stories about things that never actually happened. In psychology, it’s a working hypothesis that attempts to explain why people fabricate, distort, or misinterpret their own memories. In finance, this could hypothetically be used by someone to fill in “memory gaps” about how well or how poorly they’ve done in their investments.
This doesn’t have to necessarily be full-on diagnosed Korsakoff syndrome (which is characterized by an individual fabricating memories). Rather, in otherwise healthy adults, a phony or distorted memory is created, often through the power of suggestion (e.g. from a trusted authority figure, because of established social norms, or for some other non-rational reason).
The made-up story or memory is then accepted by the person as the truth.
This idea was demonstrated on an old 60 Minutes episode (as well as through various social experiments). The interviewer (who agreed to be the test subject) was shown several photographs of individuals. Then, the photographs were taken away. After a while, the test subject was given a “memory test,” and fake photos, which looked kinda-sorta similar to the real photos were shown to the test subject alongside photos of people which were obviously never in the original first group of photographs.
The fake photos were a subtle suggestion from the person administering the memory test that these individuals were (or may have been) in the original lineup of photographs, even though none of the photos in the memory test were in the original group of photos.
Here is a video of the test. The segment is called “Manufacturing Memories”:
Similar tactics can be (and have been) used by financial professionals to convince investors that they are earning more on their investments than they really are. For example, investment advisors are sometimes “caught” using time-weighted or portfolio returns in client reports, which only reflect portfolio returns and the advisor’s performance, but do not indicate the investor’s own personal returns. However, the implication in the client report is that the client is actually earning the portfolio return.
Another tactic used by some financial gurus is to suggest greater returns than what actually exist inside of retirement accounts. Because retirement plans are generally not taxed while the money is still in the plan, the investor may believe he or she has more money saved for retirement than is actually there (since withdrawals are taxed when taken as income). The insidiousness of this lie is that the advisor or guru can point to a hard dollar amount to “prove” that the client has lots of money saved for retirement. Of course, once adjusted for taxes, the savings is much less and may be insufficient for retirement income.
Of course, some people are more susceptible to this sort of thing than others.
Moving right along…
Another issue is selective attention and focus.
Many people believe what they want to believe… even if their beliefs run counter to objective facts. That can, obviously, be a problem in figuring out the truth of a person’s real investment return. And, in fact, a person may actually believe they have bought a great investment even though they are losing money or not making as much as they thought they would have.
A financial guru of any stripe can have amazing influence over how you see an investment or some other asset. For example, an index fund guru can influence you to such an extent that you will believe index funds outperform everything else, even when it can be shown that it’s not true, both statistically and specifically (i.e. in an individual’s specific circumstance). Likewise, a famous stock-picker can influence you to such an extent that you believe actively-managed investments will always have more potential than index funds, even when it can be shown that it’s not true (by the way, the same thing happens outside of conventional financial markets too, extending even to the life insurance and annuity marketplace).
The problem is compounded when investors are under social pressure to publicly report or prove their investment ideas work. They may, for example, paper over the fact that their index fund strategy is producing sub-par results by emphasizing the (true) fact that index funds have lower fees than most actively-managed investments. In other words, they will emphasize the positives and minimize the negatives (or ignore them completely).
Sometimes it comes down to willful blindness, where a person has evaded an issue to such an extent, and for so long, they are blind to any evidence that is contrary to their own opinion or position.
They may, for example, refuse to believe a particular financial strategy works, even when it can be proved. They may likewise believe a particular financial strategy has a great track record even when evidence is thin or non-existent.
But, even an objective observer can look at something and not see what others might think is obvious. This comes down to a simple matter of selective focus.
Our conscious mind is limited in its ability to focus on concrete events and actions. Meaning, we can only focus on maybe a handful of things at one time, and when it comes to actions, we can really only devote our full attention to one thing at a time.
This idea is explained excellently by something called “Crow Epistemology,” a term coined by writer/philosopher Ayn Rand. The source material which she used to explain this idea came from On the Intelligence of the Dog, published in Nature, vol.33 (Nov. 12, 1885) p.45.
Basically, the human mind is limited in its ability to hold multiple concretes in full focus at one time. What happens, then, is we focus on maybe 5 to 7 things or items at a time (plus or minus 2 items) and everything else takes a back seat — it essentially goes “out of focus.” We don’t even see them or, if we do, we may generalize what we see. For example, if you look into a glass jar full of gumballs, you may start to count… 1, 2, 3, 4, 5, … many…
What happened? At some point, there are too many gumballs in the jar for you to focus on each and every one of them. They all sort of blur together into “many”… “many gumballs”.
Additionally, human beings can choose what they want to focus on, and choose what they want to ignore or evade, meaning an individual can look straight at something and not see what others may think is obvious.
A while back there was a somewhat famous YouTube video demonstrating this phenomenon where a group of people are passing a basketball around. Some people are wearing white shirts and others are wearing black or dark-colored shirts. You are told to count how many times players wearing white pass the ball. To complicate the matter, everyone is constantly moving around. At some point during the video, a person in a gorilla suit walks straight through the crowd of people, stops, beats his chest, and walks off screen, but… hardly anyone doing the test sees the gorilla because they are so focused on counting the passes.
Here is the video:
Norman Nielsen Group has known about this phenomenon for years, and used it to help major corporations improve website usability. In its website usability studies, it has consistently found most people have what they call “ad blindness” or “banner blindness,” where website visitors will not even notice (let alone click on) things that look like ads — they have learned to block those things out.
Likewise, investors learn to focus on certain things, and ignore other things.
They focus on things they want to see or hear and ignore everything else. They may selectively focus on the trailing return of an investment, for example, but ignore the fact that their return is affected by cash inflows and outflows (how much money they’re contributing and how much they withdraw). They may focus on the expense ratio of a mutual fund, but ignore the impact of turnover and soft-dollar costs. They may focus on past performance of an investment class they were told is good, while ignoring other investments or not seeing certain contradictions in their preferred investment strategy. They may ignore selection or survivorship bias if they believe their favored investment strategy is a “can’t lose” proposition. They may calculate a simple average return or choose to focus on total return as opposed to compound growth rates, thus ignoring the true growth of their investment. They may ignore the effect of fees, taxes, and other costs when calculating returns… and so on.
And, thus, they may really and truly believe they are earning more than they are actually earning, for a variety of factors they may not be able to fully explain in explicit terms.
Another example: Many DIY investors rely heavily on Microsoft Excel and its IRR and XIRR function to help them calculate their own investment portfolio return. Incidentally, many financial professionals use Excel for this same purpose.
However, Excel’s IRR function contains a known calculation bug which can (but does not always) produce more than one answer… only one of which can be the correct answer. You would only know Excel’s error-prone function if you plot the possible outcomes on a graph, and even then the workaround is difficult to implement without some kind of understanding of why Excel produces incorrect answers.
This leads to an incorrect assumption about what the investor’s return on investment is, but… because Excel is an authoritative and trusted source of information, and the functions are assumed to be correct, many investors trust the answer Excel gives… even when it can be proved to be incorrect using a manual check on the function itself.
And the list of errors caused by selective focus go on and on and on.
A related issue is survivorship bias. Survivorship bias is the tendency to ignore failures and only count winners. This happens in the mutual fund industry all the time. Failed mutual funds are merged into other funds and the losses are ignored when reporting statistics on mutual fund performance.
Individual investors can do the same thing when they ignore failed investments or even underperforming investments. A person may think “hey, my stocks are doing great” ignoring the fact that only 20% of their total savings is in stocks, while the rest of their money sits in a savings account or maybe U.S. Treasuries. Or, maybe most of their money is being lost on some other investment.
Again, not all investors fall into these traps. Some folks are legitimate outliers who really are great investors.
Obviously, for an average to exist, there needs to be a significant number of people sitting on both sides of the average… people underperforming the average but also many people outperforming the average.
For example, everyone knows Warren Buffett is better than the average investor.
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.
Conversely, there is a 70% probability of not earning 12%.
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.
PostScript: Life Insurance As A Safety Net For A Good Investment Plan
The Whole Life Insurance Supplement
On the back of investments, I’d like to take a side-trip to the world of life insurance — specifically, whole life insurance.
Whole life insurance is not a replacement for investing. But, likewise, investing is not a replacement for whole life insurance.
If you’re not very familiar with how this type of insurance works, I invite you to explore the other sections of this guide dealing with whole life. The insurance can improve the overall investment return of an already-good investment strategy and act as a “safety net.” And, it is usually the centerpiece of a good financial plan.
Some folks use whole life insurance as their sole or main method of growing their savings.
The reason for this is somewhat obvious: if your long-term investment return mirrors the internal rate of return on a well-designed high cash value whole life insurance policy, what sense does it make to take an investment risk you do not have to (and many not be able to objectively afford)?
Of course, if you can earn more than what a life insurance policy earns, the answer is also obvious: invest at least some of your money — money you can afford to lose.
Want To Learn More?
If you’re ready to learn more about life insurance and how it can improve your financial plan, then click the link below and explore more sections of this guide.