Look Past the Illusions of High Returns

Physician's Money Digest, March31 2003, Volume 10, Issue 6

In Greek lore, the 3 Sirens luredmany sailors to distraction andultimate death with their sweetsongs. Odysseus, besieged by theenchanting Sirens' songs, wouldhave deviated from his journey intoruin had he not prepared himself.Likewise, physician-investors can belulled to financial distraction andruin by the sweet thoughts of highreturns. Just because your investmentsare steadily growing doesn'tmean you should wander away fromyour quest for financial solvency.You may be able to get much betterrates of return on your investments,provided you aren't lulled intofinancial apathy.

IRRATIONAL EXUBERANCE

Suppose back in the beginningof 1982 you made a new year's resolutionto save and invest in thestock market $500 each month forretirement, and unlike so manyother new year's resolutions that fellby the wayside, you stuck to thisone. It's now the beginning of 2003,you are about to retire, and youfound out that the money you havebeen putting away since 1982 hasgrown to $2.5 million.

How would you feel about it? Youshould, of course, be proud that youhad the discipline and patience tostick to your resolution. If you werelike most people, you would also behappy with your investment results;after all, you put away only $500 amonth, and now you have a prettysubstantial balance.

SIREN SONG WARNING

If you felt good about thatinvestment result, you would be thevictim of 1 or more of the 3 illusionsof high returns that most investorssuffer from. I call them the 3 c's:compounding, contribution, andcomparison illusions.

Don't fall victim to any of theseillusions. If you think you're earninga high return on your investmentswhen you're not, you won't take anycorrective action, and will miss outover the years on the opportunity toaccumulate much more money.Instead of just guessing, you shouldregularly—once or twice a year—calculate the actual rate of returnyou're earning on your investmentsand judge if it's adequate for therisk you're taking.

COMPOUNDING ILLUSION

If we asked a large number ofpeople to guess what return aninvestor earned in the above scenario,chances are most of themwould guess in the range of 10% to15% per year. Yet, it represents a6% annual return with compounding.Over long periods of time, thesnowballing effect of compounding—affectionately called the magicof compounding—helps you accumulatemuch more money than youwould have thought possible, even ifyou earn modest returns. That'swhy you should always reinvest allyour returns and hold onto yourinvestments for as long as possible.

But the same effect of compoundingcan make the rate ofreturn you earned over time seemhigh, because we can't do the properadjustments in our heads. As wejust saw, to avoid being fooled, youhave to do the actual return calculation.Don't simply guess.

CONTRIBUTION ILLUSION

As you keep contributing moneyto an account, especially if you do itthrough some automatic methodlike payroll deduction, it's easy tothink that your account is growingbecause your investments are doingwell, whereas most of the growthmay represent nothing more thanadditional contributions. In extremesituations, you may be losingmoney while the balance in youraccount keeps growing because ofthe new money you're putting in.This can really fool you in the shortrun, when new contributions maybe much larger than the goodreturns you're earning. The onlyway to know for sure is to calculatethe return you're actually earning.

Going back to our example, wasthat 6% compounded annual returna good return, an average return, ora poor return for the 21-year period?You can't tell without asking thequestion, "What return should orcould I have earned for the samerisk over the same period of time?"

COMPARISON ILLUSION

People rarely make this comparison.When making projections, theyexpect unrealistically high returns,but when looking at returns theyactually earned, they are often satisfied with mediocre or even poorreturns, with the attitude, "Whatcan I do about it now? At least Iearned a 6% return."

True, you can't go back andrelive the past 21 years. But if youhad found this out after the first fewyears, you could have done somethingabout it. And that could havemade a significant difference.

BOTTOM-LINE REWARDS

Believe it or not, despite therecent disaster, the stock market, asmeasured by the S&P 500 index,provided a compounded annualreturn of about 13% in the past 21years (ie, the beginning of 1982 tothe end of 2002). By any standard,this is a very generous return, if notspectacular. Even if you were able toearn a 10% compounded annualreturn, you would have accumulatedabout $4.25 million, instead of$2.5 million by the beginning of2003. And if you simply put thatmoney every month into an S&P500 index fund, you would haveaccumulated about $6.5 million.

That's quite a reward for keepingtrack of your returns semiannuallyor annually, making theright comparisons to be sure yourinvestments are performing well,and taking corrective actions as necessary.If you choose to ignore orsimply try to guess what returnsyou're earning, you will most likelyfall victim to 1 of the 3 illusions.

Chandan Sengupta, author ofThe Only Proven Road toInvestment Success (John Wiley;2001), currently teaches financeat the Fordham UniversityGraduate School ofBusiness and consults with individuals onfinancial planning and investment management.He welcomes questions or commentsat chandansen@aol.com.