The Most Depressing Number in Investing -- and How to Avoid it
That's the annual return for the average stock mutual fund investor over the last two decades. It's also the most depressing number in investing.
Why? Because it represents our tendency to outsmart ourselves -- and lose serious money in the process.
The average return for the S&P 500 over those same 20 years is a much higher 9.85 percent. That's a nearly five-percent gap. It's evidence that investors are needlessly throwing away millions of dollars.
Some might feel those numbers aren't a big deal. Just a few percentage points, right? Yet the ramifications for your wealth building efforts could be enormous.
Dalbar, a Boston-based research firm, has been tracking this data for three decades. The numbers provide a stark look at how investors unwittingly sabotage themselves by thinking short-term.
Here's an example: Let's say you start with $10,000 to invest. On a twenty year timeline, a 5.19 percent return would earn you a little more than $25,000.
Not bad -- but a far cry from the $65,000 you'd earn with the 9.85 percent return delivered by the S&P 500.
Those numbers are fairly sobering in their own right. Yet it's on a longer timeline where things really get ugly, thanks to the power of compounding. Over 40 years, $10,000 at 5.19 percent would net around $75,000. That's a relative pittance compared to the more than $400,000 you'd earn with a 9.85 percent return.
That's a massive gap. Think about the dramatic effect an extra $300,000 could have on your retirement. It could easily be the difference between happiness and wealth -- or a diminished standard of living.
Avoiding the activity trap
There's good news here, however. This problem is easily correctable with a simple investment strategy shift. Actively managed mutual funds tend to lag the market. For most investors, buying and holding low cost index funds provides better performance.
Fees are another key. They might seem more annoying than harmful in the short-term. Yet over a long enough timeline, they can seriously sap our savings power.
Many of us tend to put money into the market and then pull money out based on external factors. Perhaps we receive a work bonus we want to invest. Or we need cash to finance a purchase or pay tuition. Maybe we give into temptation and start chasing overheated returns.
It's difficult to avoid this kind of activity -- we're human, after all. We have real world needs and desires to be met. Yet it's important to remain cognizant of the price we pay in fees and lagging performance.
Think of it like this: An investment might return 10-percent over a decade. Yet only those who hold that investment the entirety of those ten years will receive the full benefit. You could do better if you time it right, buying low and selling high. Yet most of us will do worse. There's a lot to be said for constancy.
Unfortunately, human nature doesn't always lend itself to cautious deliberation and consistency. Dalbar's research discovered that investors tend to make serious errors during big upswings or downswings in the market. If the state of the stock market reaches critical media mass, it provokes investor action -- much of it ill-advised and reactive.
What to do next
If your portfolio's performance is lagging, consider whether you're buying and selling too frequently. This has two significant drawbacks: It turns you into a magnet for fees, and it prevents you from fully reaping the rewards of compounding.
It's also a smart idea to invest in a low-cost index fund and let the market do the work for you. Why run the repeated risk of buying the wrong investment and selling at the wrong time? History shows you're usually better off if you find a solid investment and stay put.
In fact, that's the most reliable path we have to becoming wealthier and happier.