Why “Average” Returns are Misleading

investor-behavior

 

 

 

 

 

 

 

 

 

 

 

 

Why “Average” Returns are Misleading

 

I remember back when I started my career and I was taught to focus on explaining to clients the ‘long term average return” of the stock market.  The idea was to get clients to think long term and how all the ‘ups and downs’ of the market end up not meaning much when you are looking down the road 50 or 60 years.  I think I used to say that, “the long term average rate of return for the US stock market over the past 100 years is around 9% per year when you include re-investing dividends.”  When I first started my career, saying that to clients made me feel comfortable.  However, I now feel that phrase can be misleading and not exactly true when you take into account investor behavior and the reality of how that return was generated.

First off, let’s discuss investor behavior.  I remember when I was introduced to a potential new client in her late 50’s and she wanted me to do a portfolio review for her back in early 2007.  She was already working with a financial advisor from a large brokerage firm, but just wasn’t sure she was doing the right thing.  I got her statement, reviewed it, and quickly noticed that she was 90% invested solely in the US stock market.  I called her and asked her some more questions to see if the account was appropriate.  I wanted to understand if she had other accounts that were invested in fixed income or conservative to balance out this account.  Or if she had a large fixed income source like a pension plan that she was going to live from, so this account was just long term and not needed for retirement income.  I quickly found out this was her only account and she needed all of it for retirement income because the only other income source she had was Social Security.  To this day, I still remember the exact words that came out of my mouth immediately after she told me that.  I said, “This account is wrong.”  I explained why she needed to be more conservative and reduce stock exposure immediately and she said she was going to discuss with her current advisor and get back to me.  She ended up staying with the advisor and, last I heard, she lost 40% of her money in 2008, freaked out, put all her money in the bank and says she will never invest again.  As we know now, the stock market recovered all the losses from 2008 and had she stayed invested, she would have all her money back and maybe even a gain.  However, her behavior illustrates a point.  The point that people tend to react to market events and sell during bad times.  There is a study from an organization called DALBAR that puts out an annual “Quantitative Analysis of Investor Behavior” that analyzes what kind of average return the average investor gets and the results are quite shocking.

According to the 2015 DALBAR study the average mutual fund investor earned an average annual return of 2.47% for 30 years while the S&P 500 earned an average annual return of 11.06%.  The difference between the two numbers illustrates how investor behavior plays a big role in trying to capture the return of the market.  People tend to not want to invest when the stock market is doing bad and they want to invest after they see big gains and feel comfortable.  I remember one financial advisor telling me that “the stock market is the only thing I know of where people don’t want to buy when everything is on sale!”  I consider one of my most important roles as a financial advisor is to keep clients invested during the bad times, so mistakes aren’t made.

The other part of that ‘average annual return’ is how the return was actually generated.  If you look at this chart of the Dow Jones Industrial Average, you can see how there are periods where the stock market does nothing and periods where it goes up.

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The most shocking reality is what happened from 11/1982 to 12/1999, where the Dow Jones went up 1,059% over those 17 years.  If we look at all the flat periods from 1906, there were 60 years (18 yrs + 25 yrs + 17 yrs) where the Dow Jones did nothing!  As you can clearly see, if you stayed invested over the long term, then you captured the upside potential and earn that ‘average return’.   However, you have to understand that there may be very long periods, that stretch over a decade, where the stock market produces little to nothing.  This is also a good reminder why it is important to diversify your investments.

In conclusion, the ‘average rate of return’ is a myth when you consider investor behavior and how that average return was truly generated.  I no longer simply tell people about the ‘average rate of return’ of the stock market.  I take the time to educate them about the truth of how that average return was generated and how investors can sabotage themselves through improper market timing.  I hope more financial advisors start doing this and stop giving clients what I consider a ‘false sense of security’ when it comes to investing in the stock market.  Investing is a risky proposition and clients need to fully understand the risks and find someone to work with who they can trust.  I hope you found this useful and good luck out there!

 

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