The following is a guest post from Larry Russell
Conservative, average, and aggressive portfolio asset allocations, long-term compounded returns, and investment costs
This article provides two annualized return charts to help you understanding how various portfolios have fared over many decades:
- Gross inflationary and real dollar returns for typical conservative, average, and aggressive portfolios
- Conservative, average, and aggressive portfolio returns with investment costs
These charts provide the annualized cumulative or geometric average returns for the past eighty-five years beginning in 1928 just prior to the collapse of U.S. and world stock markets in 1929. These graphics illustrate the gross returns with and without inflation that would have been achieved on various portfolio investments made in 1928. This numbers assume reinvestment of all dividends without taxation over the years and no subsequent additional investments.
This is a bit like measuring the annual growth of the “portfolio beards” of three different Rip Van Winkles (RVW) who fell asleep in 1928 and awoke at the end 2013 without each waking to trim their financial beards in the interim. Given differing cash, bond, and stock asset class rates of return, “average RVW’s” portfolio beard growth was just that — average. In contrast, “conservative RVW’s” portfolio beard growth was slower and “aggressive RVW’s” was faster.
In reality, however, the first chart below shows how the money beards of all three RVWs were each trimmed by 3.03% compounded inflation per year over these 85 years. Inflation is just a change in the value of the unit of reference. Just as the measurement of inches, feet, yards, and meters are time invariant, so should be the measurement of investment portfolios, if we wish to hold the purchasing power of a dollar constant over time.
In contrast, the level of investment costs is a choice that investors make, naively believing they will earn more if they pay more. The research literature indicates the opposite. Investment costs are just a zero sum game and a wealth transfer to the financial industry. Investment costs can be very low, average, or very high.
“Conservative RVW”, “average RVW” and “aggressive RVW” might have selected any level of investment costs before slumbering in 1928. As the second chart below illustrates, with a low return and very high costs, “conservative RVW” might have awoken clean-shaven in 2013 without any investment growth. With very high costs, “aggressive RVW” could also have awoken in 2013 with a fine beard, but did not realize just how many yards of additional beard the financial industry had trimmed away over the years.
Compounded inflationary, real, and total portfolio historical returns for conservative, average, and aggressive portfolios
The chart below displays investor portfolios with different asset allocations. The middle column is for an average investor. A conservative portfolio is measured to the left and an aggressive portfolio is added to the right.
The percentages of cash, bond, and stock in the portfolios of the average investor have fluctuated over time, but these holdings have normally been roughly 10% cash, 35% bonds, and 55% stocks. Note that the 10% cash figure is an estimate of cash for investment purposes. The average person tends to hold higher cash balances measured across all their assets, but this extra cash is typically for transactions and emergency reserves rather than investment purposes.
The conservative portfolio is composed of 20% stocks, 60% bonds, and 20%. In contrast, the aggressive portfolio is composed of 80 percent stocks 15% bonds, and 5% cash.
You should note that there are more conservative investors who hold portfolios that have fewer than 20% stocks and there are those more aggressive investors who have portfolios with greater than 80% stocks. Academic investment research supports the idea that even the most conservative investor should hold a minority stock position, and conversely even the most aggressive investor should hold a minority bond position.
In aggregate, a more diversified portfolio with a mixture of stocks, bonds, and cash tends to smooth out somewhat the more extreme fluctuations within asset classes that occur over time. In models where the need to withdraw assets may occur at random times, portfolios with mixed asset classes tended to do better over long periods, when compared to 100% stock or 100% bond portfolios.
Looking at the compounded annual return over 85 years for the conservative portfolio with 60% bonds and 20% cash, you see the real dollar return this much lower risk portfolio was just short of two and a half percent or 2.48%. When you add 3.03% annual inflation back in, then the total annual return has been about five and one-half percent (5.51%). Thus, for the conservative portfolio, about 55% of the total gross compounded annual return was due to inflation (3.03% divided by 5.51% equals 55%).
In contrast for the aggressive portfolio with 80% stocks in the third column, the real dollar return has been about 5.43% annually. When you add back the 3.03% annual inflation, then the total annual return for this higher risk portfolio was 8.46%. Thus, for the more aggressive portfolio, about 36% of the total gross compounded annual return was due to inflation (3.03% divided by 8.46% equals 36%).
Obviously over this extended 85 year period, the higher the portion of stocks in the mix, then the better the return has been. Concurrently, however, stock-heavy portfolios have experienced much greater asset value fluctuations requiring portfolio owners to have significantly more will-power to sustain a buy-and-hold strategy in down markets.
Going back to the Rip Van Winkle analogy, a great advantage that any of these three RVW’s had was that they slept through 85 years of screaming headlines about financial fear and greed. Clearly, after awaking “conservative RVW” would have preferred to have held the portfolio of “aggressive RVW.” However that is not the way investing works, because we are always awake to the latest news. The reason why the conservative portfolio is better for some investors is that it allows them to sleep at night.
Incidentally, I have written a separate article entitled: “Evaluating historical financial asset class returns: cash, bond, and stock market returns by historical periods” that you can find here: Evaluating historical cash, bond, and stock financial asset class returns by historical periods
This other article looks at this historical cash, bond, and stock return data from a different perspective. It breaks down these inflationary and real returns by various periods of time between 1928 and 2013. The article you are reading now uses long-term historical compounded averages, and obviously there have been significant fluctuations over time that are useful to understand.
For example, there have been two periods (during the Great Depression and during the more recent credit crisis and Great Recession) wherein bonds have delivered better returns. In contrast, there have been two long periods when stocks experienced huge appreciation.
While many investors remember that stock appreciation was high during the 1980s and and the 1990s, that period pales in comparison to another. After the end of the Second World War there was a brief recession and inflationary spike period that quickly gave way to a sustained stock market boom, which lasted until the late 1960’s. During this period stock valuess grew at a very strong pace.
Finally, there was another period in the middle during the 1970s and early 1980s when inflation began to spin out of control, which undermined the value of both bonds and stocks. If you read this other article of mine, you will find numerous graphics that allow you to understand this history quickly.
Investment fees and compounded annual portfolio returns for conservative, average, and aggressive portfolios
Now, let’s move on to the second slide. It is the same as the previous slide but also has some total investment cost overlay lines. This slide brings home an extremely important point that many investors overlook — excessive, unjustified, and completely unnecessary investment fees, costs, and taxes. The financial services industry has so many ways of reaching into your pocket to take parts of your annual gross investment return year after year after year …
However, much of the financial services industry has different objectives for investors. Most of the industry wants you to keep hopping and changing things by trying every supposedly wonderful new investment product and new fad that they can dream up. Unfortunately, all this does is add unwarranted fees and costs and make you pay more taxes. None of this activity helps the average investor to earn a higher gross return. Instead, it just redirects a large portion of your gross returns into industry and government coffers. The result is just a lower net return for you to live on.
Look at the dashed investment cost overlay lines on the graphic above and notice that I overlaid them only over the real dollar annual return portions of these conservative, average, and aggressive portfolio returns for these 85 years. While the financial securities industry will always use inflationary dollars, because that makes it appear like fees are a smaller portion of your returns, but this is just a numerical sleigh of hand.
Again, inflation is just another cost that erodes your total return. You should never evaluate investment performance using inflationary dollars in the first place. All that really counts is your ability to maintain and grow the purchasing power of your portfolio in the face of inflation.
Now focusing just on the real dollar compounded annual returns portions of these conservative, average, and aggressive portfolios, it becomes much more clear that the frequently uttered statement by financial advisors that “investment costs are just a few percent” is simply not true. A few percent spent on costs without a higher return turns out to be a huge proportion of the average investor’s real dollar returns year in and year out.
Also, over this history, clearly stocks have done the best job of beating inflation, while cash has barely kept its head above the inflationary waters. Therefore the industry tends to have more ways of milking the returns of stock assets compared to cash and bonds. The industry clearly understands that they must not kill the golden goose with excessive fees, and there is more gold to be extracted from stocks compared to bonds and cash.
By the way, a linchpin of the “minimize your investment costs” argument rests on the contention that the industry does not add value in terms of higher returns. However, “we will deliver higher returns” is the big lie that the financial services industry has been telling in one guise or another forever. The vast body of independent investment research conducted by objective academic analysts is conclusive on this matter.
On average across all investors the costs imposed by the industry far exceed the value delivered and there is no evidence that the financial services industry knows anything about how to deliver superior returns over the long-term. Period. Full stop. The financial services industry cannot identify superior investments beforehand, and neither can amateur investors. Nevertheless, the industry does a fantastic job of fooling the vast body of investors, while it lives perpetually off of their returns.
Average total costs for the average investor are roughly 2% per year. For the average portfolio returning historically 4.22% in real dollar terms, this means that 47% or almost half of the average investor’s gross real dollar returns would be taken by the industry. (2% divided by 4.22% equals 47%).
Perhaps you think that 2% overstates the average total unnecessary and excessive investment fees, costs, and resulting taxes that are effectively charged by the industry. However, the data supports this 2% total cost figure, and many investors pay much more than this.
You can evaluate whether 1%, 2%, or even 3% are realistic estimates of your own experience with industry fees costs and resulting taxes. Consider these investment cost statistics:
- The average actively managed mutual fund charges about 1.1% in management fees annually. In contrast, low cost index mutual funds cost around 0.1%. That is one whole percentage point of excessive fees paid without any better performance.
- Active funds have higher turnover, and higher turnover costs about two-thirds of one percent for every 100% of annual portfolio turnover. Active funds spin their wheels, and your net returns spin downward.
- If you have not yet wised-up to not paying sales loads, then about five cents on a dollar is skimmed off at the beginning to pay your adviser to tell you that the fund is “better.” However, research clearly shows that advisors have no clue about whether a fund will turn out to be superior. If your holding period is 5 years, then amortizing 5% skimmed at the outset will cost you 1% per year.
- Advisor sales fees do not stop with up-front purchase loads. There are those sneaky little 12b-1 fees of .25% and higher each and every year that many investment funds add. The purpose of these “trailing fees” is to have the advisor keep assuring that you made the correct decision. If, however, performance turns out to be lousy and you complain, that advisor will just sell you another four-star or five-star fund until that one falls behind, as well. (By the way, the “stars” only look backward, and they are completely useless when it comes to identifying funds that will have superior performance in the future.)
- If you pay a percentage of assets fee to a registered investment advisor or as part of a “wrap fee” or separately managed account, you will usually pay above 1% per year on account balances under one million dollars. Of course, if you pay such fees, you are looking for better results and therefore financial advisors usually will put you into more costly active funds. They hope that the dice turn up in their favor. This game keeps going because investors are lousy at benchmarking their returns net of advisor fees and other costs versus what they would have netted with a low cost passive index fund strategy that buys the entire market.
- If you are using a brokerage accounts to buy and sell positions, those repeated “only $10” transactions fees will mount up over time. Most investors fail to appreciate the impact these repeated fees have over time. Furthermore, they fail to understand the cost of market orders that consistently give away most of the bid-ask spread to the industry.
- All this activity leads to higher taxes. The more active a portfolio, the more likely that these transactions will be short-term capital gains, which will get taxed at your current total federal and state marginal income tax rate for ordinary income.
- Concerning investment fees for cash assets, when your bank account does not pay interest, then obviously you no return and you cannot even try to keep up with inflation. If you are paid interest but it does not cover inflation, then you are still losing. Note that even is better times before the financial crisis, the average money market mutual fund charged management fees that were greater that .5% and some charged management fees above 1%. So even if your returns were close to covering inflation, these money management fees would have wiped out any real dollar gain, given that the long-term historical real dollar return to cash was only .46% annually. (Note that if you read the fine print of money market mutual funds, you will see that over 90% of them have been waiving most of their management fees in the current low interest rate environment, so that they will not be embarrassed by a negative return on cash measured in inflationary dollars, when real dollar returns have been about minus 2%.
This is an incomplete list of excessive and unnecessary fees, costs, and taxes. Wherever you look concerning financial industry products and services (with only a few exceptions), you will find a myriad of fees and costs that shave off some of your returns without any realistic expectation of improving your gross performance.
So what do you think? Have you for years been paying 1%, 2%, or even 3% or higher in unnecessary and avoidable investment fees, costs, and taxes? If so, you have been letting the financial services industry hollow out your portfolio. Sure, you might still have a net gain, but you could have a significantly larger portfolio had you slashed your costs long ago.
Nevertheless, it is never to late to start to cut your investment fees. Millions of other investors have woken up from overly-long Rip Van Winkle slumbers regarding investment costs, and they have slashed their costs. The financial services industry emperor has no clothes, and the dot-com crash and later credit crisis and Great Recession have made that abundantly clear to many investors.
As an independent fee-only financial advisor, the author of this article Lawrence Russell, always suggests to his clients that they invest in the lowest cost, most broadly diversified index mutual funds and ETFs. Doing this reduces costs to a bare minimum and significantly improves net investment returns over the long term. Each quarter Larry updates his low cost ETFs and no load mutual fund list ebooks using rational ETF and mutual fund screening criteria that are supported by the research literature. Investors can save a lot of their money by managing their own investment portfolios without the excessively expensive fees of brokers who really have no idea about how to pick the best noload mutual funds or ETFs.