When it comes to measuring investment returns there is more than one method. The most common is nominal return which includes inflation. The other measure of return is called real return. Real return is measured by taking the nominal return less the inflation rate. Real return is vital because it measures the increase in purchasing power that your investments generate.
If Investor A achieves a 10% return and Investor B achieves a 1% return, most people would say that Investor A did much better than Investor B. Let’s now say that Investor A had to deal with an inflation rate of 10% and Investor B was in a 0% inflation environment. After inflation Investor A actually did not increase their purchasing power while Investor B added 1% to their purchasing power. This is important because even though Investor A had a nominal return that was 10x that of Investor B they can’t buy more than before. On the other hand, Investor B would have added 1% to their purchasing power. Meaning the 1% nominal return is actually better than the 10% return when adjusted for inflation.
Let’s take a look at how the three primary asset classes have performed before and after inflation. As you can see, stocks have easily produced a positive real rate of return with bonds offering a real return equal to roughly one-third that of stocks and cash-type investments producing a fractional real return.
After inflation, taxes and a recommended maximum 4% annual withdrawal rate for retired clients the only asset class that will protect their purchasing power is stocks. That is why stocks have to play an important role in a retirees investment portfolio. While bonds do not offer the same long-term growth potential they need to be included in a balanced portfolio. They are a more dependable source of income and will serve as a ballast when stocks experience periodic setbacks. And while cash-type investments are safe in the short-term they expose an investor to the risk that their purchasing power will decline due to inflation.
Morningstar has spent years studying the returns investors actually earn versus the returns the funds earned. Through this study, Morningstar has found that the behavior of an investor whether by attempting to time the market, selling during a downturn or buying after a rally has resulted in the same outcome - the average investor earning a lower rate of return.
Here’s an example - Imagine that a fund with $10 million in assets earns a 100% return from Jan. 1st to Dec. 31st. Assuming no one added or took money out of the fund it would start the next year with $20 million in assets. In the new year investors flocked to this fund adding $100 million on January 1st because of its previous years performance bringing its assets to $120 million. In year two, however, the fund loses 50% of its value. An investor who invested at the beginning of year one has broken even over the full two years while those who entered into the fund in year two have lost 50% of their investment. As a group they gained $10 million in year 1, but lost $60 million in year two. Adjusted for the timing and amount of inflows, the average investor lost about 42% annually in a fund that officially reported a 0% return over the two year period. Simply put, it is unwise to chase performance.
The average investor has underperformed the fund investments they own by an average of 1.6% per year over the long run. Over a 10 year period an investor that underperformed by 1.6% per year would have earned about $300,000 less than the fund itself (assuming a $1,000,000 portfolio, an 8% rate of return by the fund, a 6.4% return for the average investor, and no withdrawals). The gap between the returns tend to be greater for funds that are riskier (equity funds) since they invoke more of an emotional response by investors due to their higher volatility. As financial advisors part of our job is to eliminate that gap for our clients by removing the behavioral mistakes resulting from swings in the market.
On average, trying to do better makes an investor do worse. It feels great to buy more when an investment had been going up, and it hurts to buy more when an asset has gone down. An investor that tends to raise their exposure to assets that have gotten more expensive (with lower future returns) and to reduce it when they are cheaper (with higher future returns) guarantees they will underperform. Why is it that people want to buy everything else on sale except their investments?
In the end, emotional responses to market events significantly hurt the average investors performance.