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What Are Your Actual Returns?

By Ben Carlson, A Wealth of Common Sense

There was some good discussion on my post from last week about the return numbers on the S&P 500 from 1934-1953 (see Stock Market Losses With Low Interest Rates).

A reader made the comment that it was unrealistic to use S&P 500 returns from that time because there were no index funds in existence back then. Index funds didn’t exist until the 1970s. In fact, there weren’t really many mutual funds back then either. As one reader pointed out there were only 50 mutual funds or so in the 1930s.

Something else not many investors realize is that the S&P 500 didn’t even consist of 500 companies until 1957. Before that it was made up of just 90 companies in the railroad, industrial and utility sectors.

Not only were there no index funds, but the commissions were ridiculously high if you would have tried to build your own portfolio of stocks. According to Rick Ferri, if you were to try to buy a single share of every stock in the Dow Jones Industrial Average during the 1950s, commissions would have eaten up over 11% of the purchase price.

So there is some validity to the fact that it would have been nearly impossible to match the market’s return back in the day from the costs and complexity involved. There are two ways to think about this: (1) Historical return numbers should be taken with a grain of salt or (2) It’s now easier than every to earn market returns with little-to-no frictions compared to the past.

Compare the plight of investors trying to build a diversified portfolio in the 30s, 40s or 50s with today’s financial product line-ups and costs. Commissions range anywhere from $9.95 per trade to nothing at most fund firms or brokerages. There are index funds in every market, asset class, risk factor or sector imaginable. And I didn’t even mention the impact of taxes on historical returns. Vehicles such as ETFs now make tax efficient strategies available to all investors, no matter the size of their portfolio.

So while industry observers continue to forecast lower future market returns, it’s possible that investors who are able to behave will be able to earn much higher returns than those in the past on a net basis after all fees and taxes are taken into account. Gross returns on the market may have been higher in the past but part of the reason for that could have been because it was nearly impossible to easily earn those returns. Maybe investors required higher returns to compensate them for those costs.

Now investors can buy the market’s performance, basically for free, but investors continue to be their own worst enemies. This is why we see a persistent behavior gap between fund returns and those earned by actual investors. So past frictions have been erased through competition and technological innovation, but they have been replaced by over-activity and poor decision-making from investors.

I always say historical returns are always a better gauge of possible risks than they are of future returns investors can expect. It’s very easy to look back at past market performance and assume it would have been easy to earn those return numbers. Investors are much better off figuring out ways to earn as much of the performance from the market or fund returns going forward by reducing commissions, fees, taxes and unnecessary portfolio turnover.

The Power of Passive Investing

Further Reading:
On the Merits of Being a Financial Historian
Torturing Historical Market Data