If I had to pick the single largest problem in the investment community it would be irrational expectations about future returns. This comes from several sources. The primary one being overconfidence bias. And the second being widespread misunderstanding of real, real returns.
Overconfidence bias leads most of us to believe that we’re better at something than we actually are. Surveys find that the majority of people think they’re better than average drivers, for instance. Same goes for investing. No one gets into investing thinking “wow, I’m going to be really bad at this”. In general, most people get into investing because they think they’re going to supplement their primary source of income with high returns in the stock market or something like that. But most of these investors are chasing their tail in a game of limited returns and high frictions.
The misinformation on real, real returns is equally problematic. You’ve probably heard about how the stock market averages something like a 10-12% return annually. That sounds pretty good. If you can take $100K and compound at 10.5% for 30 years then you’ll have over $2 million. But the sad reality is that this commonly cited figure isn’t the return you’re actually going to see in your pocket.
It’s crucial to understand that all outstanding financial assets are held by someone at all times. And there’s a limited quantity of the instruments that generate that 10-12% return. In fact, they make up a relatively minor portion of the world’s financial assets. The majority of outstanding financial assets are deposits, bonds and other credit instruments. “The market” is actually much larger than just stocks. Deposits alone are about 13% of household net worth while stocks represent about 16% of household net worth. Obviously, most of these short-term credit instruments don’t generate anything close to that 10-12% figure. So, by definition, we can’t all generate that 10-12% to begin with because someone is always holding those lower interest bearing instruments.
For simplicity, let’s just look at a balanced portfolio of 50/50 stocks/bonds. Historically, this sort of portfolio generates a return of about 9%. If you back out average inflation of 3%, a tax rate of 25% and the average fee of 1% then we arrive at a real, real return of 2.7%. That’s less than 25% of the return cited by most market professionals, but this is much closer to the return that’s likely to go into your pocket than the more commonly cited figure of 10-12%.
Allocating your assets across the financial markets is always a smart decision. But when you’re going about this process you have to think in macro terms or you’re likely to fall into the trap of thinking that the financial markets can achieve something for you that is highly unrealistic. Being realistic about your expectations is the most important step in achieving success in the financial markets.
A few conclusions:
- The secondary markets are not a place where most of us will “get rich”. They’re a place where we allocate our savings in a prudent manner to protect us from inflation and permanent loss risk.
- Most of us will “get rich” investing in our future production and maximizing our primary source of income.
- In the aggregate, all outstanding financial assets are held by someone. Therefore, we all generate the total market return of all outstanding financial assets MINUS taxes, fees and frictions.
- Our real, real return is likely to be much lower than most of us think.