Lessons from Vegas: The Illusion of Average Returns Part 2

One key to successful investing is to realize that it's unlikely you'll obtain the average rate of return. When you invest with this thought in your mind, you'll have more realistic expectations of investment returns.

Average investment returns can be somewhat deceiving. Let’s take a look at two more examples of the illusion of average returns

Portfolio friction reduces average returns

Take a look at the chart below:

Let’s assume that you have $500,000 invested in mutual funds in a taxable brokerage account. If you applied the 10% average annual rate of return to that initial investment, then after 10 years your portfolio grows to about $1.3 million.

But that’s like skating on ice — it assumes that there’s no drag on performance due to costs.

Three big costs include mutual fund expenses, inflation, and taxes. Assuming you pay about 1% annually for fund expenses, lose another 1% to taxes on capital gains and dividends, and inflation averages about 3% per year, then your average annual inflation-adjusted, after-tax return drops to 5% annually.

So that $1.3 million portfolio drops to about $800,000. That’s about $500,000 less than what you expect based on the historical average return — no small sum of money.

From a practical perspective it means that you’d have to work several years longer to maintain your purchasing power and get you back to $1.3 million. Imagine the number of extra nights, weekends and holidays you’d have to give up.

And as we all know, medicine isn’t getting any easier to practice.

Individual investors vastly underperform market averages

An independent organization called DALBAR publishes its study of individual investor behavior and how that impacts investment returns. The numbers change some annually but the conclusions are the same.

As of 2011 for the past 20 years individual investors earned about a 3.8% annual rate of return in stocks compared to about 9.1% annual rate of return for the U.S. stock market.

You may think that investors do better with bonds, but the study shows that bond investors earned a paltry 1% annual rate of return. That was much worse than annual 7% rate of return on U.S. bonds.

What makes this so much worse is that it doesn’t even account for the eroding effect of taxes and inflation on your investment portfolio as I discussed above.

The study found two potential reasons why investor performance was so abysmal:

1. Investors tend to guess wrong, especially when the stock market goes down

2. Investors tend to hold their investments for only a few years

So remember that anytime you look at average annual returns of any investment, that average assumes that you stay in the market and don’t bail out no matter what happens. It doesn’t account for the irrational behavior many of you have when it comes to investing.

How many of you stuck it out in 2008? How many of you had the guts to buy more stocks in 2008? C’mon be honest. If you’re a mid- or late-career physician and you pulled this off, then you’d be semi or fully retired by now with the subsequent 100%-plus rate of return since then.

And you probably wouldn’t be reading this article.

One key to successful investing is to realize that it’s unlikely you’ll obtain the average rate of return. When you invest with this thought in your mind, you’ll have more realistic expectations of investment returns.

Next time I’ve got a special video for you that shows another example of the illusion of average returns. Stay tuned.