I ALWAYS get questions about 8% returns.
Aside from being a lucky Chinese number, it also tends to be the most common illustration by Financial Consultants: since it's already somewhat represented on their Product Illustrations.
The product illustration is irritatingly hard to go through and should really only be visited and objected about during a practical Financial session.
This is not because I want to deprive the public of an answer to what appears to be an outrageous fee cost (spoiler alert, it isn't) but rather because I don't have an obligation to raise the standard of the industry when a consultant often doesn't even know how to read the Terms and Conditions in their own contract.
This way, anyone who makes a appointment seeking my consultation will benefit a lot more, since its quite easy to explain and overcome.
For the most part, 8% annualized is well within my skill set - in fact, 8% net of fees, rather than the much lower return on the product illustration - happens to be my benchmark for any long term investment over 10 years.
It's also how I've beaten the SNP500 for the last 4 years by significant margins.
I would expect that if you are a modern investor (which I'm writing about next week), with all sorts of easy access to funds and ETFs with low fees or zero percent commission trades, you should at least expect significant performance and/or management if you're going through a Financial Consultant.
It is natural for cynics to suggest something silly like a lack of research on my end when I have familiarized myself with every single geography and sector, a proven track record on my part and literal articles documenting my process.
At the very least, if I am wrong, I will go down spectacularly.
Naturally, like how I have skeptics, I too have a healthy dose of skepticism for people who claim to do much higher returns than 8%. In 2021, this is sadly even more prevalent due to all the crypto clowns resurfacing.
All these things make it really important for readers to understand how annualized returns truly work. Many people will quote numbers from factsheets or hearsay from forum members.
It wasn't that long ago that people were non-stop quoting the STI ETF for 7%. Anyone with an iota of research would have noticed that the significant bulk of those returns had come from early years rather than later ones - but it's too late for them now.
Hopefully, not for you.
1) Issue Number 1: They don't understand how compounding interest works structurally
The essence of 'compounding interest' conceptually is that dividends are paid out so that you can buy additional units.
For example, if I own 100 units of a stock - and every year I have a 7% dividend that I reinvest, the following year I would have 107 units.
The next year, that dividend would be 7.49 units instead of 7 units (7% of 107 units paid out).
The next year, it would be 8.0143 units paid out. [7% of (107 + 7.49)]
If each unit was worth $1 and never grew, you would still experience that compounding growth because units beget units.
Here's the interesting part: a growth structure actually has nothing to do with compounding.
It simply increases in price.
For the purposes of simplicity, any growth stock or fund with a factsheet simply takes the measure of growth and breaks it down into how it would have otherwise compounded mathematically. An example would be something that goes up from $1 to $5 in 10 years. This is a 400% growth. In simple interest, it would be about 40% per year. But since we want to account for the 'compounding' effect, it would simply be slightly under a 17.5% growth.
Having 5 times your original capital in a 10 year period is essentially that '17.5% compounded' effect, even though the factsheet simply records the growth - it doesn't actually compound. Why is this relevant? It's because it essentially brought a 40% simple interest to a 17.5% compounding effect.
In order to project for a high compounding number, growth must be astronomically high - and that's not always realistic, especially if you only take the last few years out of context.
2) Issue Number 2: They don't understand that compounding interest simply isn't linear
I've used this example for a long time to demonstrate the SNP 500's returns.
As a reminder: THIS is the SNP500's actual performance - all dividends reinvested and not even accounting for any fees and taxes.
If you didn't read the article, this annualized return is less than 5.2%.
Meaning that if you had invested $100,000 at the beginning of 1998, you would still only have just over $275,600 by the end of 2017. That might seem like a lot, but at an 8% rate it would be over $466,095.
That's why it always worries me a lot when people talk about ETFs like the SNP500 as the end-all, be-all - because they expect a lot.
The SNP500 did 16% last year, while MSCI China did 28.7%, and my active China Fund did over 42.5%.
Yet the annualized returns for all 3 of these investment funds wouldn't have surpassed 10% annualized in the last 20 years, because annualized returns fluctuate wildly.
3) Issue Number 3: They don't understand how to deal with the risks associated with Issue 2
I was going to state solutions, but I'd much rather state problems since my experience in consulting allows me to write a lot of them immediately.
a) They are unfamiliar with the size of drawdowns
I am often amazed at how often people state they dislike expensive funds and prefer the low-cost SNP500, but have absolutely no idea of the risks associated or the drawdowns that the SNP500 has had historically.
Between 1926 and 1929, the SNP500 dropped by over 86%*.
Of course, it didn't even have 500 constituents at the time, but pundits are always talking about how if you had invested early enough, you'd have a 9-10% annualized return. The risks and interest was much higher back then, and you didn't have easy and cheap access like you have now.
b) They are unfamiliar with how how drawdown time affects them
Dot Com: -44% between 2 to 3 years GFC: -56% between 2007 and 2009 Covid: -30% between February and April 2020
The last three major crises had these drawdowns respectively, and I don't think many people understood how painful it could be to see losses in their portfolio over such an extended time, continually hoping that it would bounce back. I'd spoken to clients who had given up on investing entirely due to the psychological damage incurred from waiting years with several false recoveries. Had they known that such events were common, they might not have let go of their position and absorbed those losses.
c) They take convenient starting points when they begin their investment journey
Even Financial Consultants can be very guilty of this by showing factsheets or illustrations that suggest that the market can be ridiculously high, especially if we're only looking at the last few years in equities.
As a result, there isn't enough mitigation of risk, leading to eventual portfolio failure and low returns.
Thoughts and Conclusions
When I was writing this, I expected that I would write something geared complaining about the small-mindedness of people who have never beaten the market and how much they've lost from their reluctance to get professional advice (fear). Incidentally though, it's weird and ironic to see that I care more about the opposite (greed). I think the state of the market has been overly ambitious.
It's important to take caution about investments that seem too good to be true, especially without context.
Money Maverick
Sources
*Markets Never Forget - Don Fisher