Behind The Curve?

BEHIND THE CURVE

Market index funds like Vanguard’s famous S&P500 fund and the SPY “Spyder” on the AMEX caught on in the late 90’s, right when the long bull market turned into a crazy bubble with a blowoff top in 2000.

There are very good reasons to use index funds – low expenses, the failure of most active managers to beat the indexes consistently and the statistical trend that says stocks return an average of 11% per annum over long periods of time. A cheap route to a “sure” return in a world of unreliable fund managers and individual investors who couldn’t time the market right if they had an Olympic chronometer and three judges - looks good, huh?

Just invest, forget about it and spend your time thinking about a comfy retirement. The S&P500 returned an annualized 17% per year from mid-1982 to mid-2000. Easy money with only a couple of dips on the way.

Except – what happens to your portfolio if the market indexes go nowhere for years on end?

The statistics say that over the decades, the 11% return will keep you safe. But what if you catch a couple of bad decades? Most of us didn’t get serious about putting money in the market until our 30’s – and we planned to retire 20-25 years later. What does your retirement pot of gold look like when the “usual return” falls behind and you run out of decades to catch up?

From mid-1997 to mid-2002 the SPX was flat. From 1998 to 2003, SPX investors lost money. Ditto 1999-2004.

Break down the expected 11% return into 5-year periods. An index investor expects to bring in 70% or more every five years, depending on how often the gains are reinvested. The problem with compounding is how quickly you can fall behind. SPX investors who put in money from 1998-2001 didn’t make money.

Surely they can make that up later, right?

Don’t be so sure. A tax-free portfolio that starts with $100 and returns 11% annually should have $111 after one year, $123 after two, $136 after three years and $152 after four. Five years later it’s $168.

Think about the leap – if you end up flat the first three years, your portfolio has to rack up a 52% gain to get back on track by year four. Has the SPX returned 50% in one year in our lifetimes? Not that I can find. Forget about a 68% banner year.

The compounding you need to achieve the magic 11% is fragile indeed. If your portfolio is flat for five years and returns to the 11% norm the next five years, the 183% you should have earned for the preceding decade only turns out to be 68%. Your fifteen-year return is 183% instead of the 378% you expected.

To catch up, you need a quick five-year annualized return more like 23%. Today’s SPX would have to reach 3200 to meet that goal – and the all-time high is only 1552. Plus you have to exercise perfect discipline and never try to time the market swings yourself. Fat chance.

Dollar-cost-averaging in your IRA or 401K (buying more index fund shares every month) might smooth out the bumps, but the fundamental problem remains.

Since I took over my own portfolio full-time in 1998, I did two important things right (and dozens and dozens of things wrong, fewer each year I hope): I took advantage of the fat years in 1999 and 2003 to rack up 150% and 99% returns. And my net returns for all the other years were flat. Up or down a few percent, but no big annual losses. Ever. When the markets went into freefall, I stayed mostly with value stocks and survived.

Let me shout to get your attention – FOR LONG-TERM RETURNS THAT REALLY MAKE YOU WEALTHY, YOU HAVE TO BEAT THE MARKETS YEAR IN AND YEAR OUT. Not just match what the rest of the herd gets.

You have to do what the experts say can’t be done. Of course, if you listen carefully you find that they are really saying that most managers and individual investors DON’T beat the market, not that it can’t be done.

Hundreds of millions of people invest in stocks worldwide. If only a relative handful ever do better than the markets, that’s still several million. No reason you can’t be one of them.

All it takes is curiosity. And time. And effort.

You have to be curious enough to go looking for the best stocks, the best funds or the best manager you can find to manage your retirement portfolio. You have to read more than the headlines in the financial press, and have some idea where the broad market trends are going.

Most of all, you have to accept that in your lifetime, the market may not just hand you a fat return for nothing. You will have to earn it. The good news is that there is always a way to do better.

If you don’t fall behind the curve.