Tuesday, March 23, 2010

Realism Required On Stock Returns

Gail Marks Jarvis is a columnist for the Chicago Tribune on financial matters. The Tribune recently combined their personal finance and real estate sections into one section, which seems to make sense.

Ms Marks Jarvis provides financial advice. In a column titled "Options About for IRA investors" she wrote the following:

Financial planners have not strayed from their usual advice for people in their 20s, 30s and 40s, despite the more than 50 percent decline in stocks and the subsequent 70 percent upturn.

If you have years to go before you retire, you are likely to make more money in stock funds than in CDs, said financial planner Gary Bowyer. On average, bonds gain 5.5 percent a year, while stocks return 9.4 percent. Although some years are awful, Bowyer said, gains close to the average are likely over 20 or 30 years.

The first and most crucial mis-characterization comes in the first paragraph; she mentions that stocks declined 50% with a subsequent 70% upturn. While this may technically be true, it will lead many people astray; it would SEEM that if you went down 50% and then up 70% you'd be "net" up 20% (70% - 50%) if you weren't very good at math or didn't pay attention to the subtleties of the market. However, it isn't like that at all; if you have $100 and then it goes down 50% it goes to $50; a subsequent 70% rise means that now it is at $85, so you are still DOWN $15 (or 15% on your investment, ignoring the fact that you lost a year towards retirement that you can't make up, which means that it is an even bigger loss than it appears).

I would agree that most "financial planners", who make their living selling financial products, would tell you to keep on investing in stocks (mutual funds) and other types of products that earn them money; but it isn't true that this is the advice that you will find out there at large nowadays (just keep putting money in stocks and it will be all right).

As far as stocks returning 9.4%, that is completely fanciful. Stocks have been DOWN for the last decade, and for it to return 9.4% you'd have to make up all that lost time plus the time value of money. Many planners are urging a much more conservative rate assumption than that. About the only people that use such high rates as assumptions are pension plans that are trying to avoid future cash infusions and yet pay out high payments to retirees.

There are many instances where the stocks aren't regaining their past highs; look at the NASDAQ index which peaked at above 5,000 (5,132) but is now near 2400. The Japanese stock index (NIKKEI) peaked at 38,916 but is now near 10,800.

This is not to say that you shouldn't invest in the stock market; but nowadays very few people would view it as sensible to assume such a high rate of return on stocks unless you discount the last decade or so plus the experiences of NASDAQ and the NIKKEI, among others. I also think that the 50% / 70% comparison is misleading to most investors.

Cross posted at Trust Funds for Kids


Dan from Madison said...

Stocks are essential to any portfolio, but the bond market is where it is at and other instruments besides stocks. Preferreds, convertibles, corporate paper, and hybrids of the above are where the action is right now.

Also saying that stocks went "down 50%" or "up 70%" is crazy - does that include the dividends that were paid? Many stocks have pretty attractive yields that I assume they aren't including in the calculations. Getting paid to wait until the stock goes up before selling is also a decent strategy.

Anonymous said...

Carl, everyone should thank you for the math reminder. BUT, how many of those that lost 50% made 70% in recovery?

Anonymous said...

Hey, in just 10 days I can read your blog on my IPAD !

Carl from Chicago said...

Great on the iPad. Did you get the full wireless one or the one that runs on wi-fi? Also good but sad point that likely many folks bailed out at the low and didn't even recover on most of the gains

Anonymous said...

WiFi only.
I have covered our home with 3 access points. Concrete walls are tough for wifi to get thru. Each uses the same SSID and password, but different frequencies. So you can roam at home but may need to re-enter passwords if you move from one access point to another. A bit different than cellular service.
A 3G/4G cellular to wifi box, portable, is in the cards for us. I can use it traveling (or as a home backup service) and access internet on laptop, iphone, ipad or whatever. Usually these devices allow multiple simultaneous connections. Currently 4G has limited offerings, but by the end of 2011-2012 it should in widespread use especially in metro areas, and offered by several cellular cos. Right now Sprint has 4G wimax in Chicago. Verizon and ATT will follow with 4G LTE soon, hopefully this year.
Currently on the road its not too hard to find wifi.

Carl from Chicago said...

Very cool

When you get your ipad you should take a photo or two and write up what you think about it and send me an email and I can post it up here