Understanding Investment Returns

At our firm, we find that once clients are settled into practice, they have disposable income that they are channeling into 401(k)s, other retirement plans, and brokerage accounts. We often encounter questions about the mechanics of investing. This article is intended to clarify the topic of investment returns.

Many of the folks we work with remember the heady days of the eighties and nineties, where the stock market was on a seemingly endless ride up, yielding extraordinarily high returns. At the time, people expected returns of 10-12 percent, and were disappointed with anything lower. In the early 2000’s and even through today (2016), we have been seeing returns more in the 6% to 8% range. From 1928 through 2015, the S&P 500 has seen a compound annual growth rate of 9.5%.

Fueled by media hype, and companies that want to sell product, rather than focus on goal-oriented planning, it’s easy for clients to get caught up on returns. As a practice, we don’t encourage chasing returns - it’s too risky, and for the most part, doesn’t work out well for the investor. Most importantly, chasing returns often results from a common failure in reasoning called the 'myth of average returns.'

The Myth of Average Returns

The myth of average returns is the incorrect assumption that if you average out various rates of return over different time periods, then that average will be the same as your actual rate of return. In fact, a negative rate of return over a time period will require a larger positive rate of return to recoup your losses. Here is an example to illustrate the myth of average returns.

Say you have $100,000 invested in the stock market and your account loses 10% in value today. Now you have $90,000. A few weeks from now, the market recovers and is back up 10%. Great news? Not really. Your account balance is now $99,000, not the $100,000 you started with. So you’re still in the red, with a net loss of $1,000. 

If you want to recoup your 10% loss, you actually need a 12% gain. Based on market history your investment portfolio would have to stay more aggressive to obtain those types of returns.  The lesson being, the hit you take in down markets hurt you more than the comparable gain. On paper, this is a harmless exercise. In real life, it’s pretty painful.

What’s an Investor to Do?

Instead of chasing the next hot investment tip, we recommend creating a well-diversified portfolio of stocks and bonds, designed to reduce the effects of a drastic downslide. Your asset allocation needs to reflect your time horizon and your risk tolerance. Hypothetically, if you were to have 70% of your portfolio in stocks, and 30% in bonds, the bonds will have a cushioning effect during a down stock market. Much like driving a car requires both a gas pedal and a brake, so do the elements of your investment portfolio. One will be pushing you forward, while the other is designed to slow you down.

Active Versus Passive Management

Beyond being diversified in stocks and bonds, your portfolio should also have diversity in management. Some of your assets should reflect what is going on in the market; we do this by using index funds that mirror the S&P 500 and other current trends. This is known as passive management. You should also be invested in actively managed funds – run by professional money managers who are actively seeking new investment opportunities.

Discipline Wins the Game, Not Chasing Returns

People want to know how to ‘get ahead’ in the stock market. And while everything we have mentioned – the myth of average returns, building well-diversified portfolios, asset allocation and active-passive management, all matter, the most important thing is to actually do it!

If you don’t have a systematic savings plan, you won’t be able to reach your retirement goal, regardless of how well the market performs. It’s as simple as that. Find an experienced financial services professional who takes a goal-based approach, and who can help you adopt a suitable and systematic plan to get you to where you want to go. 

TH-200144