Past Performance Is Not A Guarantee Of Future Returns

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Quite often on The Simple Dollar, I’ll put up a description of a financial situation that one of my readers finds themselves in, or I’ll create a straw man to illustrate the point. I’ll give an age and a situation, and then apply an investment choice to that person to see what happens when I knock over the dominoes.

Invariably, someone will comment that the assumptions about some aspect of the illustration is wrong. “You can’t possibly expect to earn 12% over the long term in the stock market,” one person will say. “Only assuming 5% wage increase each year? Anyone with any gumption will beat that,” says another. “What if the person gets fired?” says yet another person.

And they’re all correct. If you change the assumptions around so that the situation is as they describe, you do draw a different conclusion, and the assumptions that they provide are realistic.

So what’s the point of looking at such situations in detail, then? The point isn’t to convince everyone that they must invest in a Roth IRA, even though it’s a good idea – one can always create some situation where it doesn’t make any sense. However, by looking at real situations, one can see the benefit of investing in a Roth IRA.

One particularly good example of this is with my recent MSN article on how to retire at age 40. In it, I made a number of positive assumptions about investments to illustrate the idea that a young person, if they were serious about investing, could actually retire at age 40 and do whatever they pleased. The purpose of the article was to illustrate that if you’re a financially prudent person, you don’t have to spend your entire life working and following the rat race, but it takes some discipline to do it.

In response to that MSN article, another blog, Mighty Bargain Hunter, took another look at some of the assumptions in the article, pointing out that they were in fact very positive assumptions, and then re-running the whole idea, revealing that retiring at age 40 might not be as simple as I made it in the article. And he’s completely correct – with a very realistic (perhaps slightly pessimsitic) set of assumptions instead of the more rosy ones I used, it will take much longer to retire.

Another favorite of mine is the ongoing debate over the Vanguard 500. The Vanguard 500 is an index fund started in 1976 that precisely mirrors the S&P 500, a collection of the stocks of most of the largest companies in the United States. Since its inception, it has averaged a return of over 12% per year. Given that, I often use a 12% annual return as a number to use to calculate annual returns in the stock market over a long term (longer than ten years).

Routinely, a blog commenter will comment that there’s no way that the S&P 500 will continue at this rate. They’ll use their own evidence by using a longer period of time than that, including S&P 500 returns from before 1976, or they’ll state an economist’s predictions about the future of the stock market over the next several years.

I will never be bold enough to say that I’m absolutely correct and the 12% annual average will hold up, but if you ask me what I thought, I’d say that it will, at least for a while, and I’d dump several reasons on your lap. Someone else would likely disagree with this and deliver several reasons why it won’t happen. I know at least one person with a degree in economics who firmly believes that the next several years will be much better than 12% as several new industries come online with marketable products. Who’s right? Only the future can really tell.

What can we learn from this? Any time you read an sample story about someone’s specific situation – whether it’s on The Simple Dollar, in Money Magazine, or anywhere else – know that in order to actually tell a story, you have to make some assumptions. No one knows what the future may hold in any financial situation. The person in question could get a new job tomorrow that raises their salary significantly, or they could get a pink slip. The stock market’s bottom could fall out, or we could enter into an incredible bull run where everyone makes a mint.

All we often have to base these scenarios on is the past, and past performance is never a guarantee of future returns. You can make up all the scenarios in the world, but if the stock market takes a giant lurch or someone discovers a universal cancer cure or solves the traveling salesman problem, almost all of them will be shattered.

So why have a scenario at all? Every scenario teaches something. It shows what can happen if you save money or if you spend it. It shows what can happen if you save for retirement. It shows what can happen if you make more frugal choices. It can turn a vague idea into something we can all imagine – and when that happens, it becomes something we can all reach for and hope to touch. Scenarios put a face onto ideas, and by putting on that face, it turns an idea into something we can relate to.

When you read another story about Joe and his financial choices, remember one thing: Joe’s no different than we are – he just wants to make the best choice for his future, something we all want to do.

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14 thoughts on “Past Performance Is Not A Guarantee Of Future Returns

  1. Warren Buffett said that he has NEVER met a man that could forecast the market. I believe him. 12% compounded would be an above average return….especially in light of inflation, expenses, and taxes. 12% is just an awfully cheerful forecast in my book. Much depends on the price you paid for your investment. Those that paid a better price will have the best returns. Most who invest in the broad averages never ask “how much” when they allocate their funds.

    Those who allocated funds into the averages in 2002 or early 2003 have a far better compound than those who allocated funds in say 1999/2000 when market prices were extended.

    You have to ask yourself “How much is it worth cuurently?” If you lack the ability to figure it out then it is always best to resort to dollar cost averaging. Broad diversification does not protect one from paying rediculous prices for their share of American business.

    Warren Buffett said it best…”We prefer to be greedy when others are fearful, and fearful when other are greedy”.

  2. By the way, I’m not a big fan of mutual fund mechanics. I’m not investing in the market. I’m investing in the business. When I buy shares, I become a fractional owner of that business. So I’m looking to choose a concentrated portfolio of great businesses with a product or service that has some sort of enduring competitive advantage. I’m looking for a business that generates a lot of cash, has low costs(not capital intensive) generates high returns on equity, and has trustworthy, capable, owner oriented management that knows how to allocate capital at high reurns. Finally I want to pay a reasonable price for such a business. It is rare that I would ever lose money because such businesses as these almost always increase in value over time.
    Wells Fargo, Johnson & Johnson, and American Express come to mind. Anheuser Busch is a great business currently selling at a great price. Owning the businesses directy greatly reduces costs by eliminating the fund houses and middle men. You can buy such businesses directly through their direct stock purchase plans and dividend reinvestment plans.

  3. One more thing…

    You can set up such plans through sharebuilder.com, moneypaper.com, or visit the respective company’s website and click on investor relations. That should tell you if the company has a direct stock purchase plan and from there you will be directed to their transfer agent. Some companies require you to own one share of stock before enrolling. This can be done through moneypaper for a fee, or you can purchase that first share from any broker. Some companies do not require that you own one share…so you could enroll immediately with them.

    In addition to solid iconic American businesses with impressive track records, one might also consider certain REITs(Real Estate Investment Trusts)..such as Washington Real Estate Investment Trust(WRE)…. (writ.com) That one has delivered fantastic returns over the years, and has paid increasing dividends all along the way.

  4. But you’re needlessly exposing yourself to additional risk.

    Or to put it another way, you’re accepting more risk, but receive no more reward.

    You can’t diversify away non-market risk by picking a few individual stocks, as you can with mutual funds.

    One of the clearest examples is the common mistake of investing 401k funds solely in the company stock.

    Plenty of people here locally rode their Lucent 401k from $600,000 down to $60,000.

    There are many low-cost mutual fund families available (Vanguard comes to mind)

    >Owning the businesses directy greatly reduces costs by eliminating the fund houses and middle men.

  5. Yes but Lucent doesn’t qualify as a business with low fixed costs, impressive free cash generation, owner oriented management who has/had a track record of allocating capital at high returns and also a tarck record of funneling profits to stakeholders(via dividends, share buybacks, etc), high returns on equity, enduring products/services(moat). I don’t think Lucent ever passed these qualitative tests. It certainly has never been on my radar in a qualitative sense. Rapid growth does not always imply value. The very nature of itsbusiness model implies caution(rapidly changing technology. Change is never good forthe long term investor. Proctor & Gamble comes to mind.A great consumer business where a great deal of change is not nearly as likely. Besides…the money doesn’t know where it came from. A dollar from Tide detergent is as good as a dollar from a Telecom equipment maker…although their might be more romance in owning the tech stocks. But again themoney will never know the difference. Ilike the predictability that P&G will dominate consumer products for years to come. The brands are awfully strong in their portfolio and their distribution is 2nd to none. I wouldn’t lose a lot of sleep owning companies like P&G, Wells Fargo, American Express, Anheuser Busch(50% of the beer market and rising), Johnson & Johnson, etc.

    Risk lies in not buying with any sort of margin of safety…never asking how much is it worth(as you would when buying a car, groceries, a private business, a house, etc)

    Broad diversification at best will ensure average results. The winners will offset the losers(and vice versa) and you’ll end in the middle perhaps…unless you paid a high price for your piece of American business(index fund)….in which case you will always do a liitle less than the average compound.

    There is much more risk in buying the averages at any price(never asking “how much” than buying a great business like P&G at a good price.

    You will never do better than the averages by buying the averages. A high percentage of managed funds fail even to match the averages over the long run. Concentrating in great business and buying them at a good price will almost always yield better results. But again, each investor has to realize his/her limitations. If he/she wants to be passive and not do any homework, then it might be good advice that he/she dollar cost average the low cost index funds.

    I would never advocate that anyone concentrate their 401K into their company stock for sentimental reasons(Enron, Lucent, Cisco, etc). So I’m on record as saying that is usually a bad idea…although Danaher(DHR) shareholder-employees have done super over the last 15-20 years. You have to make these capital allocation decisions from a purely busines perspective.

  6. But I’m not saying that buying low cost index funds is a bad idea for the passive average investor.I’m just saying that you will do infinitely better with them if you try too seek asmuch value for your investment dollars when you do buy them. Buy them when the yields are highest.Buy them when stocks are well liquidated and it isn’t popular to buy stocks. Buy them when there isn’t anyone left to run out of the markets. Back up the truk.Never say “Hey, I’ve got $5,000 and I’ll think I’ll put this in an idex fund tomorrow. Wait a minute and evaluate the value. Your results will vary widely based on when you buy the averages and at what price you are paying versus the value at time of purchase.

    It only takes average intelligence to do this. You only need to do a few things right over your investment lifetime to get superior results. Slow down..because activity does not increase returns. Show a little patience and discipline. Wait for the fat picth. You can stand there with the bat on your shoulder. In baseball you will strike out looking, but with investing you are never called for a 3rd strike looking. Wait for the fat pitch. That’s all I’m saying. Hit it out of the park!

  7. Hi Trent,

    I read that article (possible to retire at 40) when I saw it on MSN’s home page. It was very thought provoking, even though I couldn’t have done it at such a young age.

    Just out of curiosity do you get paid from MSN for those articles (15 ways stores trick you into spending) or just an increased awareness/traffic to your website?

  8. Kevin, the problem is in identifying that fat pitch. Most folks don’t have the time or the education to truly research the market. In fact, it’s amazing how much most people don’t know about financial markets. The more they don’t know, the better it is for them to invest in general choices like index funds.

    However, I do agree with you that if you want higher returns, you should do the research and wait for the right time.

    Gal

  9. You must have mis linked to that MSN article, the link you provided doesn’t work.

  10. Kevin:

    You need to read this page:

    http://en.wikipedia.org/wiki/Efficient_frontier#the_efficient_frontier

    No matter how good you think you are at picking individual stocks, that approach always results
    in you being below the efficient frontier (see
    the second graph on that page)

    Individual investors don’t have access to the tiniest fraction of data available to a mutual fund portfolio mananger (neither do they have a full-time research staff)

    You are accepting far more risk than necessary
    for whatever current rate of return you are getting.

    Or to look at it another way, for the risk level with which you are comfortable, you could receive a higher return with a more efficient portfolio.

    Trent really ought to do a post on modern portfolio theory, or why picking individual stocks
    is ALWAYS an unneccesarily risky approach for the individual investor.

  11. The only way to reliably do better than the whole market is with private information. The whole market is the sum of all the individual equities, so for any subset that outperforms the market there is a subset that underperforms. I’m not aware of any methods for timing or selection that work reliably (nor how there could be such a method that would continue to work after people learned of it)–not that I don’t invest in individual stocks as well a sector-based mutual funds and ETFs and do my best, anyway. Aswath Damodaran has written a number of books about various rules of thumb for stock picking and their pros and cons (e.g., _Investment Fables_, which has this supporting website). He shows the downsides of value investing, contrarian investing, growth investing, picking stocks based on low P/E, high dividends, etc.

  12. I do plan on retiring by the age 40. That is, retiring from employment. It does not mean I will stop working, what it means is I will stop working for other people and have my money work for me instead.

    Life is too unpredictable to count on a nest egg without a steady cash flow from assets. That is all a retirement fund is, a nest egg.

  13. Sadly, I have to agree with the Mighty Bargain Hunter on this one. I just wanted to point out that you left out the random factor, which plays a VERY large role.

    You can live frugally, save and invest at high rates, but still lose your savings due to a fluky medical condition. I know. I’ve seen it eat though savings. Earlier problems are worse due to the lack of compounding. You might not retire at all if you need a group-based insurance plan.

    Then there’s also a random market dip around your retirement date. Timing of those random events makes a huge difference. There’s no actuarial table for the S&P 500.

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