Traditional investing claims that any attempt to time the market or actively trade to gain an advantage will most likely not work. In fact, many articles have been written to tell you that any success that is achieved by actively trading is only a short term phenomenon. Additionally, this out-performance will not sustain itself. But is this actually the case? Surely someone has figured out a better way of investing than to simply watch your accounts move up-and-down with the economy?
Bear with me. We need to draw the question out a little further. Unfortunately, a simple answer to these questions is only likely to confuse the issue. Furthermore, the simple answer will fail to actually identify what is being asked.
Here is what typically happens. A person who reads articles in various publications that addresses methods for investing, are often only seeing articles that are taking into consideration one number, "average return." Whenever you read things like "86% of active large-cap fund managers failed to beat their benchmarks" the measure that's being considered is the "average return." Articles with titles like this tend to lead people to ask the next obvious question, "So who are the 14% who did beat the benchmarks?"
Passive fund managers, and 401(k) plan providers who favor Index Funds, push the idea that "average return" is the only thing investors should be concerned about. And it is easy to agree with them. In fact, I dare to say that in any given 15 or 20 year time frame, if you the reader, were to look at your investment accounts and try to decide which account you were most happy with, you would undoubtedly point to the one which provided the best "average return." So just give me a list of the 14% of fun managers who did beat their benchmarks!
Here's the problem, it doesn't matter who the 14% are.
The Problem With Average Return in Retirement
I'm going to provide you with two investments where something other than the "average return" is more important to you. Consider the performance of the following two portfolios while taking withdrawals from your account.
If you are retirement age, it is past time to consider something other than "average return." What you will notice on the chart provided above, is that the "average return" rate for Portfolio A is higher at 7.59% than the 6.77% for Portfolio B. Yet, because of the extra investment performance volatility of Portfolio A, Portfolio A lands almost $300,000 short of Portfolio B.
The reason that this happens is simple to understand. If I have $100,000 and I intend on taking out $5,000 and then I have a portfolio loss of -50%. Now my account is down to $50,000. In this circumstance, if I still take out the $5,000 I was originally planning to spend, its as if I've taken out $10,000 on a $100,000 investment.
$5,000 / $50,000 = 10%
$10,000 / $100,000 = 10%
Additionally, recovery does not happen in a linear fashion. If you lose 50% of your investment, you have to get a 100% return just to get back to even. Imagine that you have $100.00 you lose 50%, or $50. Now you have to double the $50 just to get back to even.
Average Returns Can be Deceptive
Consider the S&P 500 Price Return Index. Morningstar reports SPX an average return of 4.86 over the last 15 years. The question is this: "How many times in the last 15 years has the S&P 500 Price Return Index returned 4.86% +/- 2%. Meaning, between 2.86% and 6.86%."
The answer: Twice. 2 out of 15 or 13.33% of the time. Average returns are unpredictable and can lead to mistakes made by investors. Furthermore, the push by those who favor passively managed funds often cite data that essentially states that the average return is the only thing an investor should care about. Unfortunately, this attitude may unwittingly put investors at risks that they are unaware of, seeking higher returns, not considering the risk being taken to get those returns.
What Measures Should Be Considered When Investing?
Not all active fund managers do very well. But there are important statistics like Alpha, which measures the excess risk adjusted return, that can be used to judge an active fund manager's performance. By using Alpha, you can more accurately determine if a fund manager is getting more return for the amount of risk that they're taking compared with a benchmark. Compare, for example, the Fidelity Contrafund (FCNTX) with the S&P 500 Total Return Index. FCNTX has an Alpha of 1.8% for the last 10 years. Which means that for the level of risk that is being taken, FCNTX is earning about 1.8% more per year on average. Utilizing investment advisors who understand how to read risk-adjusted measures of performance can be a critical way to overcome the average return trap in investing.
Written by Kyle McCauley
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