In steps the Stock Market, promising higher returns than
stodgy old bonds, and money market accounts; hence, the
stock market became the destination of choice for
retirement savings and Wall Street responded by increasing
the offerings to retail consumers through Mutual Funds.
Before the year 2000 it was not uncommon to hear that the
S&P returned 16% over the previous 10 years. Looking at
the returns of one of the best known indexed mutual funds,
the Vanguard 500, returns since its 1976 inception are
11.75%, impressive until you look at the 1 year return,
-2.41%, the 5 year return, 11.89% and the 10 year return
5.06%. These are average returns not real returns. As an
example let's look at the growth of 1 dollar in the
mythical High Fly Fund. High Fly posts a 50% gain in one
year and your dollar grows to $1.50. The next year it
posts a 25% loss, now your investment is worth $1.125. The
average return for High Fly reported by the mutual company
is 12.5%, but that is not your actual return. Your actual
return or compound annual growth rate (CAGR) is in the
neighborhood of 6% per year worse if you factor in
inflation.
Is 6% acceptable given the risk that investors take on by
investing in the stock market? David F. Swenson, CIO of
the Yale Endowment explains investor risk in his book,
Unconventional Success, when he states: "Because equity
owners get paid after corporations satisfy all other
claimants, equity ownership represents a residual interest.
As such stockholders occupy a riskier position than, say,
corporate lenders who enjoy a superior position in a
company's capital structure." He goes on to say "the 5.0
percentage point difference between stock and bond returns
represents the historical risk premium, defined as the
return to equity holders for accepting risk above the level
inherent in bond investments." Mr. Swenson's comments and
calculations of the risk premium were based on a compound
annual return of 10.4% in the stock market compared with 5%
bond yields. 10.4%-5% equals a risk premium of 5.4%.
Unfortunately I have yet to find a calculation of CAGR
(compound annual growth rate) that matches Mr. Swenson's.
I found many examples of average returns that match the
10.4% average growth rate but not the CAGR. The reason
that this is important is that all other savings vehicles
are quoted by the CAGR. Your savings accounts, bonds and
money market account are all quoted by the CAGR or its
equivalent, the annual percentage yield (APY). In order to
determine where to allocate your funds, you must compare
apples to apples not apples to oranges. As you might guess
the CAGR for the stock market is lower.
A quick look at the CAGR calculator for the stock market on
moneychimp.com shows the average return from January 1,
1975 to December 31, 2007 to be 9.71%. You only realized
that return if you were invested in the market the entire
time. What if you began investing in 1980? The numbers
look about the same. If you started in 1985 your returns
look a little better. By 1990 the CAGR drops to 8.21%. If
you started in 1995 your CAGR jumps to 9.32%. If you began
investing in 2000 your CAGR drops to minus 0.06%! If you
eliminate the results of the past 7 years from the S&P
performance and track performance from January 1, 1975 to
December 31, 1999 the CAGR was 13.03%. When the stock
market is good it is great, when it is bad, it is pretty
darn miserable. For the record, there has been only one 9
year period from January 1, 1950 to December 31, 2007 in
which the average return for the S&P was 16.14% and the
CAGR was 15.32%: the period from January 1, 1990 thru
December 31, 1999.
It should be clear from these numbers that your returns are
dependent not only on how long you are invested in the
markets but when you started investing. In fact the stodgy
old bond investor has outperformed the stock investor over
the past 7 years.
The 1990's investor will have a very different view of
market performance than the 2000's investor.
Mr. Swenson's book is a must read for anyone investing in
mutual funds, he makes a compelling case, explaining why
actively managed mutual funds are generally a money losing
proposition for investors and why a balanced portfolio
based on six solid asset classes constitutes the winning
combination for investors.
How can I call the stock market the second biggest
financial scam of the twentieth century if I am quoting
numbers that are on the face of it pretty good? For four
reasons:
1) because the true CAGR going back to 1950 is much lower
7.47%. It will take the average American worker 25 years
and one month saving $10,000 per year to accumulate one
million dollars in wealth as long as the market achieves
CAGR of 9.71% and in 29 years 2 months if forced to accept
the longer term returns of the market. These numbers leave
very little margin for error for the average American
worker. Retirement projections for the most part are based
on returns that have existed at only one point in the stock
market's history since 1950;
2) because the same laws that facilitate the transfer of
individual investor money into the stock market also
mandate its withdrawal at a specific time which is
tantamount to what all financial pundits have called a
money losing strategy, Market Timing. In other words the
laws governing tax-deferred savings mandate that
withdrawals begin at age 70 and a half at the latest
forcing retirees to time the market to determine their exit;
3) the time horizon for capturing meaningful gains from the
market is long indeed, at least 30 years. To quote Mr.
Swenson, "Returns of bonds and cash may exceed returns of
stocks for years on end. For example from the market peak
in October 1929, it took stock investors fully twenty-one
years and three months to match returns generated by bond
investors."
Charles Farrell, an adviser with Denver's Northstar
Investment Advisors, used data from Morningstar's Ibbotson
and Associates to analyze 52 rolling 30-year periods,
starting with 1926 to 1955 and ending with 1977 to 2006
"But here's what's interesting: The Majority of your
wealth would almost always have come in the last 10 years.
Mr. Farrell calculates that, on average, you would have
notched 8% of your final wealth after the first decade and
32% after the second. In other words, 68% of the total sum
accumulated was amassed in the last 10 years." (Wall Street
Journal, Jonathan Clements November 21, 2007);
4) because current marketing strategies by financial
pundits, gurus and Wall Street treat stock market investing
as a money in, money out proposition obscuring the true
risks of investing and the true time horizon needed to
accumulate wealth. In other words, the money needed for
retirement must be invested for an extended period of time,
roughly 30 years. It cannot be borrowed against. It
cannot be used to buy a home, car, pay for college or a
child's wedding.
It can only be used for retirement 30 years hence. Any
other needs must be paid for from an additional source
other than retirement savings. Most people lack the
financial education to understand this and blindly chase
market returns hoping for a big score.
Fortunately there is a simple solution, but like most
simple solutions this one requires work and financial
education. I will introduce this simple solution in part 3
of this series.
Disclaimer: This is a thought-provoking article that draws
upon real world examples, articles, books and websites that
are readily available to the public. This article is not
intended to offer investment advice. Any actions that you
take in the market place should be the result of your own
financial education and consultation with a licensed
professional. Financial calculations were accomplished
using the savings goal calculator found at Bankrate.com
unless otherwise indicated.
----------------------------------------------------
Ouida Vincent is an active real estate investor and
entrepreneur who has watched her friends and family members
struggle under the burden of home ownership and poor
returns in today's market. She is launching
http://www.freeagentnationonline.com to promote financial
education and entrepreneurism.
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