Realistic Rate of Return – Part III

Realistic Rate of Return – Part III

In Part I of this series I talked about how important it is to come up with an accurate rate of return when doing financial planning.

In Part II I talked about my asset allocation being 100% stocks and some of my rational for that and briefly touched on some of expected rates of returns for stocks and some of the reasons why most individual investors can’t attain those rates.

In Part III of this series I am going to try to justify why I am not following the smart path of investing in index funds.

First off let me start out this post by saying that if I were giving advice for someone else to follow I would recommend that they put all of their stock investment money into index funds. They are the most consistently successful way to invest in the stock market and in the long run for the very large majority of people will provide them the best long-term returns in the stock market.

Now here’s where the hypocrisy starts and I welcome anyone to call me out on any of my rational. I do not own any index funds.

Despite the overwhelming statistics that individual investors picking stocks and actively managed mutual funds fail to beat the markets average around 80% of the time I am trying to be one of those people who beats the odds. Here is my rational.

1. When I hear the word average I associate that with poor performance. Not trying to sound arrogant here, but generally in life I’ve found myself above the “average” bar. I mean look at the average American. The average American got C’s in school, doesn’t graduate from college, has a 0% savings rate, doesn’t pay off their credit card every month, buys a new car every few years, is woefully under prepared for retirement, is overweight, lives paycheck to paycheck, and doesn’t read 72 finance blogs and financial websites a day :P.

I generally tend to put a little more effort into things than the average person and this usually pays off for me. Most people who invest in individual stocks don’t spend the time to learn enough to be successful. The want fast results with little effort and that pretty much epitomizes the qualities and end results listed above. I love finance and love using my mind to make me money, so when it comes to investing I tend to think maybe I have some of the qualities that might lead me to into that minority that beats the market averages.

The above points kind of explain why the average person doesn’t beat the market, but I think it’s also important to look at the “average stock” to see why I am optimistic that I can beat the average stock market returns. As was kind of pointed out above average includes everything. Even though most people you may know have a college degree, got Bs in college, doesn’t carry credit card debt, etc. you have to include all the people that dropped out of high school, are on drugs, can’t get a job, and have racked up hundreds of thousands in debt and declare bankruptcy. Granted the other end of the spectrum (Warren Buffett, Bill Gates) is included too, but you get my point.

Even though the average stock market return is roughly 10% it includes lots and lots of very bad stocks. Stocks of bad businesses with no profits and poor business models. Now granted hindsight is everything, but without a whole lot of effort you can likely weed out a very large chunk of stocks that are bound to perform poorly. Of course you will have your Enrons and WorldComs where everything seems nice and peechy and then crap hits the fan, but that is why you diversify your holdings. No one or two stocks should be able to sink your portfolio overnight. But getting off-topic here a little, and I’m already writing a book. In summary I think I can work to be an above average investor and that I’ll use those skills to pick above average stocks.

2. Even though this is not great logic, I’m young and feel that I can afford to take some risks, maybe I have some knack for investing and it would be a shame to at least not give it a try to see if maybe I can beat the market. If it turns out that 5 to 10 years down the road I can’t earn above average returns, yes I will have potentially thrown away some returns by not at least meeting the average, but even if I earn 0% or even lose money I will still be better off than a very vast majority of people when it comes to retirement nest egg, will have learned my lesson, and can switch my money over to index funds, and still be able to enjoy a comfortable retirement .

3. A vast majority of mutual funds are very short-sighted and don’t invest for the long-term. They are judged by their performance over the last year or quarter and not over decades. Most investors don’t have the patience to wait out a few bad years and so mutual funds are constantly jumping in and out of stocks trying to churn a fast profit to get more people to throw their money into the fund. This in turn creates poor performance in the long-run and I think skewes the results that can be attained by doing your due diligence up front and holding the same stock for 5,10, or 20 years. So that statistic that 80% of mutual funds don’t beat the market average can be largely attributed to the fees that it costs for holding the mutual fund and the fees the mutual fund itself incurs by trading in and out of stocks so much chasing short term gains, and not as much about how incredibly difficult it is to choose good long term investments.

4. I’ve been drinking too much of the Kool-Aid over at Fool.com and feel empowered as an individual investor. After visiting their site daily for a couple years I went a head and subscribed to one of the stock picking newsletters run by Tom and David Gardner themselves. While I don’t necessarily agree with anyone who just goes and buys stocks based on what some investing guru says (Ex: Jim Cramer), I have really bought into the Fool philosophy of investing (sip…..mmm good kool-aid) and best of all a long with stock picks that have a pretty darn good track record (roughly 25% annualized returns in the four years its been around), they provide pretty in depth analysis on why they choose the stock and there are tons of resources (much like in the pf blogging community) that are full of great ideas and advice on how to better improve your stock picking prowess. Anyway I’ve been using some of the picks generated from this service to narrow down stocks that I buy for my and my wife’s Roth IRAs. So I’m kind of cheating off someone who has the time and skills to do a lot of the grunt work for me.

So what does this mean for my expected rate of return? Well theoretically I should maybe bump it up a few percentage points if I truly do believe I can beat the market, but I am not necessarily confident I will be able to do so and I may very well fall flat on my face. So despite my lofty ambitions I will leave my return rate at whatever I deem to be the average for the stock market as a whole, probably 10%. This will kind of be my benchmark to weight my actual returns against. If 5 to 10 years down the road it turns out that I am only meeting this average or worse yet losing to it, then it does not make sense for me to put the extra effort and risk into picking individual stocks and will switch to index funds and will be able to leave my rate of return in my calculations the same.

Ok and now that I have come to the end of this long rambling post about personal investor empowerment and above average reutns I just realized I’ve sort of been misleading you through this whole post. I actually do own index funds. In fact my 401k which makes up roughly half of my retirement savings is invested in various index funds. So I guess take that into account before you let me know I’m a complete fool for risking money in individual stocks without having a clue what I am doing. Again I’m definitely open to criticism.

In part IV I will talk about inflation and how I usually go about taking this into account in my calculations.

Part I  – Introduction
Part II
– Asset Allocation

[tags]Investing, Annualized Return, Financial Planning[/tags]

  • Michael

    A couple of points:

    Realize that most “average” folks invest in mutual funds rather than individual stocks. So most of the trading that takes place is done by professional managers, so you will be competing against people who do trading for a living, not against the “average” investor.

    Any information you glean from investment newsletters is likely to also be known to these professional managers, so it will be difficult to exploit.

    You will have to spend a significant amount of time doing research, and still run the risk of underperforming “the market”.

    If you want potentially better returns than the US Stock Market, you could invest in index funds which cover riskier segments of the market: small stocks, value stocks, emerging market stocks. (Someone who owned bonds could also increase their stock percentage, but that is not applicable to your situation). This would remove the risk of you underperforming “the market” without any reward.

    I applaud the fact that you realize that buy and hold is a better strategy than jumping in and out of hot funds, but I think you are underestimating the difficulty of only buying “good funds/stocks.” If it is easy, the professional managers will know this as well, causing the price to rise to the point where it is properly valued. This will reduce the potential return that you could earn.

    10% returns in the near future is probably too optimistic for the broad market. Estimates based upon earnings and dividend growth are predicting closer to 7%. Better to be conservative when you are using that number to decide how much you need to save each year to meet your retirement goals.

  • My Financial Journey

    I agree about being conservative with the numbers, irregardless they won’t affect how much I save, at this point I save every penny I can scrounge up.

    Also good points about the difficulties of picking individual stocks – I am probably more on your side than my side, but at least for now I see myself venturing out in this arena. As I said I may fall flat on my face, but I will document everything and you can come back and check periodically on my progress. I’m working getting all my investments on a page and providing annualized returns for each portfolio (IRA, 401ks)

  • A few thoughts:

    First the three part post was great!

    Second, I’m all for the investor empowerment, but don’t drink the Fool’s Kool-Aid about their stellar performance. They have had outsized returns, its true, but they invest in small cap stocks, and small caps have been very succesful over the period they selected (they sent me an ad letter, and were busy comparing themselves to the S&P, which is an inappropriate benchmark for their portfolio. (Otherwise, why not compare themselves to bank accounts or commodities?)

    Third – averages are interesting, but what happened to the guy who retired in 1932 and needed to start selling? Index funds, while having high averages, can also have massive drawdowns. Slightly lower returns for much lower risk is probably a good tradeoff.

    Finally – by focusing on a few really good ideas, you can obtain outsized returns simply by avoiding dilution of your best ideas (with index funds this is impossible). Actually, one of the greatest weaknesses of the Mutual Fund industry is the fact that they have to purchase such a large basket of stocks in order to qualify.

    In short – I agree with you, and try to avoid indexation, though in a 401(k), you don’t have much choice, do you?

  • My Financial Journey

    Doug –

    1) Thanks on the compliment, I hope to add a few more parts to this series, but this last week was a busy one for me.

    2) I agree 100% with you that the Fools generally stick with smaller companies and they have had one heck of a run as of late. Comparing their returns to the S&O 500 is an inappropriate benchmark in my opinion. I think they should add a small and mid cap index in their comparison too, or at least a Total Stock Market index. That being said at this point in my investing career I able to give me investment ideas that I would not be able to come up with entirely on my own, I hopefully plan to change this situation.

    3) A good point, but when it comes to retirement time, I would hope that a majority of the funds you need for retirement are in safer investment vehicles such as bonds and high dividend paying securities.

    4) I agree that if you know what you are doing holding a very large number of stocks is probably not the best idea, I believe Warren Buffett once said something to the effect that diversification is for people who don’t know what they are doing. At this point in my career I believe I need to diversify.

    5) Also agree that with a 401k you don’t have much choice but to index. All my individual stock picks are picked for my and my wife’s Roth IRAs which I max out every year.

    Thanks for the great comments!!

  • You are right – you always have to keep your eye open for good investment ideas. I like to read Forbes for investment ideas. You can get their “advice” columns by going to Forbes.com, go do opinions, and then select investments from the menu. they have about ten columnists and pick two every issue (every two weeks).

    Keep the great posts coming!

  • Jay

    I have become pretty jaded with the market as of late. It seems like there are no such thing as “good stocks”. Companies with solid growth and profits get hammered for lame reasons while garbage stocks shoot up crazy. It just seems like nothing is based on fundamentals anymore. Its all about hype, and what side of the bed the analyist woke up on, or as i seem to think, who is lineing his pockets.

    The buy and hold technique could very well be the only answer to this. But dicipline is key, how much percentage loss are you willing to stomach with the hopes that one day your battered ‘good stock’ will return to its glory days? The only other thing i can think of is to hedge yourself with options.

  • My Financial Journey

    Yeah thats the great part about long term buy and hold, I’ve had stocks shoot up 60-70% and others fall 30-40% in the span of a few days, but it really means nothing if you are in it for the long term. For the most part I plan on holding everyone of my stock picks at least 10 years. Ups and downs don’t bother me at all the. Also I don’t have a load of money in any one stock.

    You can’t tell anything by the short-term fluctuations in the market. It’s not based on any real logic, movement over 5+ years is based upon the companies performance. Use the short term nonesense of the market to pick yourself up some good companies at bargain prices.

  • David

    I like this post and it’s always encouraging to see someone want to “take the reigns” and control their future.

    One of the biggest problems and one of the major drawbacks that the individual/amateur investor has going against them is that yes they are competing with professional money managers, but they are also competing in an environment with a huge question mark.

    Government regulation is the kiss of death for financial markets, and it has been steadily growing since the 1920s (despite the Dems and Republicans claim that deregulation caused the current mess – it’s absolutely ridiculous if you look at the facts, but that’s another story altogether).

    So, not only do you have to be right about the companies you are investing in for the long-term. You have to now be certain that the Government won’t fire your management, or nationalize your company, or pass laws that influence the industry you are investing in or pass laws that indirectly influence the industry you are investing in, or that the Federal Reserve won’t raise or lower interest rates and cause a flood of credit to various industries and be certain that if any of that happens that the management of your companies knows how to deal with all of these changes…

    …on top of that, you have to be forward looking on Government policy for 20-30 years…policy that often encourages companies NOT to be forward looking but rather pragmatic and short-term to deal with the “regulation of the year” or the “monetary policy of the year”.

    That, is something I have NEVER heard anyone tell me that they could or have successfully done. To some degree it turns into a crap shoot and you could potentially get all the investment and fundamentals right and still lose out just as you hit retirement because you did not play the role of an infallible expert economist.

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