Why Stock Market Returns Matter, But Not for the Reasons You Probably Thought

I've been known to quote stock market returns from a Compound Annual Growth Rate (geometric mean) point of view.  This calculation takes into account the effect time has on a rate of return and is wildly more useful than simply looking at average rate of return (usually quoted as the arithmetic mean).

But any good hardcore day trader or even the wannabe home gamers in the investment world should quickly ask a disarming question: “so what?”  So the markets have traditionally failed miserably to consistently post a year over year positive return over the course of the past decade.  There are still people who make money investing in equities, even your precious insurance companies.

And you know what?  They are correct.  The point about annual growth rate in the stock market has nothing to do with an “Us vs. Them” debate and everything to do with a management of expectations.  There are plenty of people who have made money in the ups and downs of the market, the only problem for you is, you're probably not one of them.

Unless you happen to work as an analyst or fund manager for a major Wall St. firm or other managed asset group, I'm betting 99% of the people who read this will lack the technical knowledge and/or the wherewithal to successfully traverse the volatility of the markets and pull off a winning (read: appreciating in value) strategy.

On top of that, I'm willing to bet .5% of the remaining 1% couldn't pull it off consistently even if they had the know how and resources, it's tricky stuff.

So what's the point?

Contrary to the message retail investment firms want you to believe, the stock market isn't really a friendly place for the buy and hold strategy.  Instead it's a volatile world, where attention to detail, and happening to be in the right place at the right time, are everything.

If you go scouring the Internet for detractors of Jim Cramer (the crazy guy who shouts out stock picking tips on CNBC) you'll find plenty of recorded examples of his bad calls.  Including his infamous miss-step concerning Bear Sterns, a call over-which he back-peddled painfully and stated he was referring to the notion of pulling money from an FDIC insured account.

And how many times before and since then has Jim offered up personal banking advice to a caller?

Hint: if you divide any number you want by the answer, you'll get nothing more than a pissed off calculator.

Let's not forget Jim's background.  He was a hedge fund manager for several years with a pretty impressive track record.  So, if Jim Cramer can make bad calls (and he admittedly does it all the time) you can, too.

Mitigating Risk

So how does one manage to get into the market and not lose their shirt?

Scalability.

That's the whole idea behind a registered investment company (also known more commonly by it's colloquial name: a Mutual Fund).    The premise is, if you and I and all our friends (and yes some people whom we'll never meet or know) all pool our money and give it to someone who really knows what they are doing, we can take advantage of a group of people whose job it is to study the market and ensure they use our money to make money.

Does it work?  Yes.

So if it works, how come DALBAR tells us that the average mutual funds investor has only managed a measly 4.5% over the past 20 years?  Two things:

  1. That 20 years includes the entire past decade, which was a terrible time for the stock market
  2. Remember this?  That's about what we should expect.

The first point is relatively self explanatory, but point number two needs a little more explanation.  From the monte-carlo simulation we know where the near 100% probability lies–around 5%.

Keep in mind that getting in, getting out (in some cases), and staying in a mutual fund isn't free.  Those asset managers want to be able to pay their mortgages and go on vacations too you know.  So after fees (and keep in mind we're talking about a wide array of funds out there) we get to DALBAR's numbers.

But where's the +20% I'm hearing about from my neighbor that he's getting with “his guy?”

Chances are good your neighbor is lying, but we'll set that one aside for a moment.

It's out there, but a lot of it is reserved for the people who don't mind throwing caution into the wind.  The Hedge Fund industry is a great place to look.

It gets criticized for being an unregulated product; this merely means that hedge funds aren't subject to the same regulatory headaches mutual funds are…big deal.

This claim is more sales tactic on the mutual fund side than practical advice to you and me.

Still, the Hedge Fund industry gets it wrong, too.

Since 2009 the HFRI, one of the major indexes that measures results in the Hedge Fund world, has lagged the S&P 500 (not good).

For what it's worth, I'd be a tad remiss (and I'd certainly upset my Hedge Fund friends) if I didn't mention that despite lagging the S&P on average for the past 3 years, Hedge Funds had much less ground to recover following 2008 as the HFRI dropped only 20% compared to the S&P's 40%.

The Money is Made on the Up and Down Swings

Those who post the biggest gains on the market are traditionally those who manage to successfully buy and sell at under valued and over valued moment respectively.  And the mutual fund industry is well aware of this.

The average turnover rate in a fund is in the mid to high 80% range, meaning funds are selling and replacing almost all of their holdings within a one year period.  Most of the retail investment salesmen and women want you to believe buy and hold is a good practice, but they'll happily sell you a mutual fund that has no track record, nor any intention of buying and holding.

We learned some time ago that the stock market has been traditionally very unreliable as a vehicle to realize consistent point to point returns any where near the commonly quoted return rates.  The one exception being a period when a completely new sector entered the U.S. economy and rapid advancements (along with some help from new legislation) made stocks available to the general public in a fashion that had never before existed.

So How do I make any Money?

You probably saw this coming, managed assets.

Mutual funds are ok, but be careful as this industry (though fairly tightly regulated) can cost you more in terrible investment strategies than the fees they charge ever will.

Hedge Funds are way more sophisticated and probably a better bet, but again prudence is crucial.  If you've never done this before, and don't feel like spending some time learning the ropes, you're probably better off staying away.

Then we have insurance contracts…

Yup that's right, annuities and cash value life insurance are both managed assets.  When you place money in either contract, (as long as it's a fixed product) the money goes to the issuing insurance company's general account, which is a huge collection of money that gets invested according to the style of the company's investment manager and/or CFO.

But it's not just the investment results.

You're also investing a little in the insurance company's ability to be profitable when you place money in one of their contracts.  As the company makes money from it's daily business activities, they can use this profitability to enrich the cash benefit you realize in your life or annuity contract (this is much more the case under mutual companies, but even the public guys can be competitive from time to time).

But are these Insurance Companies any good at Investing?

Well, with an industry average yield on assets of around 5% you'd first think, “well, they don't do that much better than the average mutual fund investor,” but you'd display your ignorance for all the world to see.

They are producing these numbers with a portfolio that is required by law to be mostly bonds, and when we say mostly bonds, we mean something like 90% bonds.  And let's not forget again, that's the average.  There's a good number of them doing much better.

Remember 2008's scary crash?

Wish you had the good sense to move completely out of the market, or at least the fund manager(s) of your mutual fund(s) did?

Well both Guardian and New York Life were certainly not timid in screaming from the roof tops that they both did this very thing.  We also know that indexing has done very well over the past decade, and that's primarily made possible by the use of financial derivatives that insurance companies purchase with the majority of the money they collect for indexed products.

What about Indexed Funds?

Indexed funds are sold for their low fees and their appeal to the buy and hold mantra.

Does it work?  There are some statistics out there that claim index funds outperform 80% of actively managed funds, and this is where the buy and hold types start to get really excited.  Of course, what they fail to recognize is how much better the 20% that beat the index funds do.

No one has really analyzed long term competitive results between active and passive management, or at least we're not aware of anything (if you know let us know).

So keep in mind that the stock market has had a tough time delivering a consistent return long term, with one exception that's not likely going to come back any time soon.

People are still making money on the stock market, but not the same way the people at the retail investment sales firms are claiming.  If we start at 2011 and work back, we'd have to go all the way back to 1995 to come up with a start year that realizes an 8% return CAGR, and that's only true for the money that was invested in 1995; everything else since then has performed worse–and in some cases much worse.

There are plenty of people who did better than that in the same period, but again, their strategy wasn't buy and hold stocks.  It's also important to mention that the S&P itself doesn't necessarily buy and hold.

It, like almost all indexes, removes stocks that decline in value to a certain level or go away, and this doesn't really effect the index.  If you want to follow an index that encompasses the entire market, the Willshire 5000 is your index, not the S&P.


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