Two friends are enjoying a stroll in the New York City Harbor admiring the opulent yachts.
One friend turns to the other and asks, “Who owns these beautiful boats?”
The second friend replies, “Those belong to the investment professionals on Wall Street.”
First friend nods, then asks, “Well where are their clients’ yachts?”
“They can’t afford them,” the second friend says implying it was obvious.
Hollywood movies about investing or Wall Street nearly always relate someone’s success with an average return. This person earned 35% this year! Look at the life they live!
We ask, if average return is a language, is this the right language for the client to be using to discuss financial success? We say it is not that easy. The truth is that you cannot spend a return, but you can spend dollars. Achieving above-average returns does not necessarily equate to never running out of money.
So why do we talk about average return as often as we do? Because, just like in Hollywood movies, we want to sum up our investing life story into a brief, exciting tagline. And, just like in Hollywood movies, we are missing a lot of very important information...The dollars that go to the client!
Let us preface that this is all hypothetical in nature.
Hollywood Average Return = 10.79%
Consider this hypothetical portfolio that has an average return of 10.79% over the past 40 years. We simply added up all the annual returns and divided by 40. We easily arrive at your average return of 10.79% each year. If you started with $10,000 in 1978, you would have $603,462 today.
I think most people would boast about that return. After all, they have increased their initial investment by a factor of 60!
With Volatility = 10.32%
However, we know the market just doesn’t produce the same average return year after year. It goes up or down, accelerates or slows. This is when the Hollywood return stops working, when you look at the dollars.
It is possible to lose money with a positive average return. Therefore, you need to use the Geometric Average Return, which accounts for the compounding effect that occurs from year to year.
Consider this example: You start with $10,000 and you lose 10% of your investment in your first year. You now have $9,000. The next year you earn a 10.5% return and you now have $9,945. You have lost $55 of your original investment.
Arithmetic average return = 0.25%
Geometric average return = -0.28%
So, we include the volatility in the same sequence of returns that produced your 10.79% Hollywood return. The $10,000 that you started with in 1978 is now worth $507,874 and your geometric average return is 10.32%. This is $95,588 less than the Hollywood return!
With Fund Expenses (0.74%) = 9.57%
What is a fund expense, and why don’t I know about it?
Every investment fund will have a fund expense ratio. This is the fee that the fund manager charges to manage the pool of investments. A fund’s expense ratio can range from 0.02% to over 2.00% of every dollar you have invested in the fund. Here is the rub: Your financial advisor doesn’t have to tell you!
The average expense ratio for actively managed funds (those trying to “beat the market”) is around 0.74%. Our highest all-in portfolio fund expense at Aspire is 0.11%. These fund expenses are nearly unavoidable, but they can be managed and limited.
Including the drag of fund expenses, your $10,000 that you started with in 1978 is now worth $387,523 and your correct return is 9.57%. This is $215,939 less than the Hollywood return!
With Advisor Expense (1.00%) = 8.57%
Our idea of a financial advisor is service-oriented, and rightfully should be. True financial planning considers the impact that all expenses have on your life, including our own advisory fee. Our success is based on you accomplishing the goals of your financial life, so the client should always be informed of how their advisory fee is accounted for in spending those dollars.
Unfortunately, there are plenty of financial advisors who do not provide financial planning services. Their job was to sell you on investment products designed to “beat the market” and the conflicts of interest were plentiful. Their success was judged on his or her Hollywood average return, and that was the language of the conversation.
Including a 1.00% advisor expense, your $10,000 that you started with in 1978 is now worth $268,092 and your correct return is 8.57%. This is $335,370 less than the Hollywood return!
With Taxes on Dividend and Interest = 7.86%
Let’s assume that your $10,000 was invested into a taxable account and the income (dividends and interest) that the investment products generate will be taxed each year when earned. This limits the principal that can be used in compounding returns, but, just like the fund expenses, this tax liability can be managed and limited.
We assume the portfolio provides 3% of income, or yield, each year. This will be 50% interest income from bonds taxed at an income tax rate = 24% (hypothetical). The other 50% is dividend income from stocks taxed at long-term capital gains tax rate = 15% (also hypothetical). We assume the net amount after paying taxes is reinvested back into the portfolio.
Including the taxes you would pay each year on yield, your $10,000 that you started with in 1978 is now worth $201,480 and your correct return is 7.86%. This is $401,982 less than the Hollywood return!
With Inflation = 3.14%
In 1965, a Porsche cost around $6,000. Today, a similar Porsche can cost well above $90,000.
This is inflation at work. It is a constant battle against the dollars generated by our returns. Sure, you may have earned a return of 18.72% in 1981, but inflation was 13.50%! You earned a real return of 5.22% on your assets. It can also magnify your losses, just like in 1982 when your return was -0.85% and inflation was 10.30%. You lost 11.15% of your purchasing power!
The average inflation rate from 1978 to 2018 is 3.41%. Let’s apply a constant rate of inflation for the sake of brevity.
Your $10,000 that you started with in 1978 is now worth $52,690 in today’s dollars and your correct real return is 4.45%. You have only gained $42,690 in purchasing power. Moral of the story, don’t let the big numbers fool you.
Conclusion
True financial planning requires managing and accounting for each of these expenses. We aim to control what is controllable and to provide you with realistic expectations of what goals you can accomplish in dollar terms. A Hollywood return may convince you that the sky is the limit and you have $603,462 to spend away. However, in dollar terms, you should be planning your goals with the considerations of spending $201,480. Imagine the difference this makes.
When your investment success is dictated by you accomplishing your goals, it transcends average returns. Next time someone wants to have the conversation about their Hollywood return, tell them what you plan to achieve. It is a much better story to tell.
Disclosure:
This presentation is for illustrative purposes only. All of the figures were based on relevant information, but not derived from any actual portfolio, advisor expenses, yield, taxes, or inflation. The information regarding fund expense ratios was found here: https://www.morningstar.com/content/dam/marketing/shared/pdfs/Research/USFundFeeStudyApr2018.pdf?cid=EMQ_
The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities. This information in no way guarantees any future investment results.
The returns were obtained from the benchmark indexes used in the Aspire – Balanced portfolio from 1978-2017.