Sunday, November 14, 2010

How come all those investment experts make returns of 20% and higher and I don’t?


When reading newspapers about 'experts' making 15, 20 or 30% on their money, it is for many of us enough to get an inferiority complex! Here take my money and get me those returns as well! Please, please!

Guess what, most investors and Gurus don't make those returns. You may have been promised such returns, but the real life returns are quite different. Part is the selective memories of 'experts' advertising those returns. In the year following a market crash, a 20 to 40% return is quite often achievable, but when you include the returns of the previous year when the crash happened things may look a lot less exciting. Besides, the 'expert' may quote you the returns on his best performing fund, rather than on his money losing fund. And finally always remember the adage: "past performance is not a guarantee for future performance".

When we make an investment, we often evaluate the potential returns of an investment. We make a guess, e.g. a real estate property based on our APOD should throw off 4% cash on cash invested and a total ROI of 21%. Wow! Let's invest; what are you waiting for? Well this is our best guess when things go as we want to! Nobody expects failure, but I can assure you that I have failures and others do to; even worse, it WILL happen to you! We call that risk!

In our economy, we expect our savings to provide us a return! But the return you will be getting is determined by the current economic conditions and the conditions of the economy in the years to come. It is a matter of... investment capital supply and demand. Historical performance reviewed by authors such as Jeremy Siegel show that stocks over longer periods of time (25 -30 years) return after inflation 6.5 to 7% annually which is much higher than fixed income return. In fact, according to Siegel, the difference between fixed income and stock returns is 3 full percentage points. He calls this the risk premium - compensation for the short term risk or volatility in stock valuation. When expressing this risk as the percentage that a stock at a given time deviates from the average value trend (referred to as 'mean reversion', one may assign the following risk to Bonds, T-Bills and Stock prices over time:
Holding Period
Stocks
Bonds
T-Bills
1 year
18%
8.5%
6%
2 years
13%
6.7%
5%
5 years
7.8%
5%
4%
10 years
4.8%
4%
3.6%
20 years
3%
3.4%
3.2%
30 years
2%
2.6%
2.8%
(Copied from Siegel's graph in figure 12.2 of 'The Future for Investors')

In the short term, deviation from the average price appreciation trend of stocks is enormous (18%). However over the longer and especially over the very long term this risk level decreases to even less than that on a T-Bill. Thus one can conclude that if T-Bills are considered lowest risk (you get the entire principal back upon expiry and collect interest while holding the bill), then the higher returns of the other assets reflect the higher risk or short term volatility in the investment class valuation. Apart from risk, investment returns should reflect the ROI on the investment class that is least volatile in the short term. Those assets are T-Bills and the return on investment money is then expressed as the T-Bill yield.

When we buy an investment, we evaluate that investment based on our expectations of what the profits will be. We may anticipate returns of 10 to 20% or even higher. We the investor, base this expectation on the risk level that we perceive this investment may have as well as on the risk level that is build in the overall market price of the investment. This is what presents us with 'buying opportunities'. However, our perception of risk or that of the market at a certain time is not necessarily right and here lays an important source of investment losses or excessive profits.

No-one will ever invest in order to lose money and thus we all have the tendency to expect returns higher than they will be in real live. Some individuals may be extremely good at recognizing high return opportunities, Warren Buffett comes to mind. But even he makes mistakes and his average return is probably lower than he estimates at the time of investment. By using bench marks such as Jeremy Siegel's we can estimate how we measure up against the average market and the average return on a particular investment class. Unless we are pure investment genius, we should be satisfied with these returns which are often sufficient to make us wealthy over time.

Yet, there are many investors who do not earn those average ROIs and we can now also see why. They simply take on too much short term risk and thus they are often forced to sell rather than being able to hold on to their investments long enough to achieve the average return of the asset class they invested in.

One last point we should never forget, Jeremy's long term returns are based on the entire market. If you invest in only one or a few investments, the risk that such investment fails is much higher than that the overall market will fail. Yes your returns are potentially higher, but so is the chance you will lose all your money. Thus always ensure you have not all your eggs in one basket and be a diversified investor. Next time you see the Guru with his high returns, ask yourself what the risks were the Guru took and what his investment time horizon was. You will likely realize that you are not doing so badly after all and that there may be a need to educate yourself but that there is no need for an inferiority complex.

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