Why outperforming the S&P 500 must become a priority for younger investors

This is a longer than average post, but if you are in your 20s, 30s or 40s and are counting on a decent retirement based on a financial planners' estimate of a 10% market return or so, I suggest you stick with this and read it through. For many readers, this will be eye-opening to say the least.

The following diagram is from work of Steven Johnson of Simcivic.org and illustrates what he believes the future composition of the return rate (see below) of the S&P500 is likely to be (with inflation extracted): (Future returns above: Click to enlarge)

In this diagram, Mr. Johnson has outlined what he believes the constituent parts of future stock market returns are likely to be (inflation excluded). This shows a 4% return or so, compared to a historical 7% return (again, inflation excluded), which he calculates as having been historically produced by the following constituent components (see below: historical return):

(Historical returns above: Click to enlarge)

Adding inflation back into both figures, produces an anticipated future return rate of about 7%, versus a historical 10% or so. While a 3% differential doesn't sound large, over a 30 year period, this differential amounts to $10,000 being turned into $76,122 (7%) or $174,494 (10%). [Both figures now include an inflation component of an additional 3%.]

As you can see, the difference between these two figures could significantly affect your retirement planning. Mr. Johnson makes a pretty compelling case that the returns of the past cannot be relied upon as a reasonable guide for indicating the returns of the future. It's different this time he claims: this time in a negative sense!

In the paper Mr. Johnson argues that stock market returns arise from two primary sources. These are capital growth, historically accounting for about 2.3% of the 7% long-term (ex. inflation) rate; and dividends - including re-investment and share-buybacks - accounting for about 4.6% of the 7% (ex. inflation) historical return. Together, the two components produce a ~7% return (1.023 x 1.046 = ~ 7% return).

Mr. Johnson then further deconstructs the return to be able to analyze what might happen in the future, given known trends. The capital return factor (~2.3% historically) is the result of three things:

1. Population growth in the 20th century of about 1.3% per annum;
   
2. Plus rising productivity of about 2.0% per annum;
   
3. Less a lag factor of about 1%
   

Producing a net 2.3% factor on the capital growth side.

On the dividend side, the components there are the actual dividends paid compared to the overall economy and the market capitalization of the stock market, compared to the overall GDP. Historically over the past seventy years, this has averaged 65% or so.

The ratio of dividends paid, measured by the GDP of the economy has remained relatively constant, at about 2% of the GDP. Accounting or adding for stock buy-backs, this figure rises by about 1% to become about 3%.

The 3% dividend figure is then divided by the denominator, which is the ratio that the stock market has been capitalized at compared to the GDP of the economy (historically about 65% as a long-term average), produces the aforementioned 4.6% figure.

Reiterating, the two components produce a ~7% return (1.023 x 1.046 = ~ 7% return).

Mr. Johnson argues that in the future, these underlying rates will be different (mostly lower), due primarily to two trends:

1. Population growth is slowing, and he uses a 0.2% annual estimate (from Social Security figures) instead of 1.3%. This alone lops off more than 1%.
2. The stock market has gradually been valued as a higher and higher percentage of GDP. This is the denominator of the dividends return portion. In fact, this appears to be on an upward trend that Mr. Johnson believes may average out at 120% of the GDP, nearly twice the historical level. Given the massive trend of the average person now investing in the market - compared to being a rich man's playground 50 years ago - it's hard to argue with this idea, even if the figures might not prove exactly right. Dividing the dividends of 3% by the average capitalized 120% ratio produces a dividend yield of about 2.5%, some 2% below what Mr. Johnson estimates this portion historically produced.
   

Incidentally, the falling yield portion as a value of stocks is pretty indisputable, and can be seen on one of the numerous charts within the paper that help make all this understandable, and compelling.

Hopefully, I have explained this well enough that most people can understand the basics of it, even if some of the subtly is lost. I cannot impress upon you strongly enough that you go and read the paper yourself, and try to understand the implications for your retirement planning.

I will be writing more on market outperformance in the future, and re-visiting some ideas from some of my older postings.


JW

The Confused Capitalist

Salute to Abnormal Returns

Disaster has struck!

Abnormal Returns, the finest investment blog in the blogosphere, has decided to take a brief break from the task of blogging. How will I get my daily fix of top-quality investment-related information?

Whether Abnormal was writing on behavioural-related investment issues; or on portfolio allocations and the need to provide advice that does no harm; or about thinking more critically sharply about positive studies you might be hearing about; or about the prospect that a commodity bubble has occurred (or least that future returns in this sector are likely to be relatively weak); or theme-oriented aggregations (such as this example on fundamental indexes/ETFs); or one of my personal favorites, a posting on "proxy investing", Abnormal brought a great deal of insight or information to our attention.

Even when I disagreed with the thesis, there was no mistaking that this was a very knowledgeable serious investor here. And a damn fine writer too.

And of course, there was the daily litany of links, many well-outside the investment world per se, that highlights an active, curious and and interested mind.

The writer of this blog and the writings herein have directly benefited from the active mind of Abnormal Returns. Abnormal Returns is, in my opinion, by a country mile the best overall investment blog out there, one that I visit daily, and cannot recommend too highly. I therefore grant Abnormal Returns the highest honor as shown here ...
May I suggest you visit or revisit Abnormal Returns for edification, erudition, and illumination?


JW

The Confused Capitalist

I love you, I really, really, do

Are investors too much in love with stocks these days?

The reason I ask this question is obvious, given the recent Dow Jones records, but my interest was piqued by accidentally tapping a link that took me to the msn money web-site.

The so-called "Stock Scouter" on the site purports to show that in three categories of a) sector type, b) investing styles, and c) market capitalization ranges which is "in favor", "neutral", or "out-of-favor". Guess what?!

In all three categories (sectors, styles and capitalization ranges), there isn't a single thing that is "out of favor". Is this one of those contra-indicators, suggesting that the market is priced to perfection, with nowhere to go but down?


JW

The Confused Capitalist

Learning, ever learning

One thing I love about the markets, is that there is so much to learn. To become a better investor, you must want to learn more and then put that knowledge to use.

Stockcoach recently wrote a great posting about one of his favorite sites to learn from, CXO Advisory. I too enjoy the insights that this site affords.

To become better in the markets necessarily involves continuous learning, both about strategies that can better the market, and also your own inner human psychology.

Many strategies to beat the market are fairly simple, straightforward, and well known. Studying these things for a while, allow you to come to know them. Further incremental improvement is possible, by learning more advanced techniques. However, many market-beating strategies, it has often been said, can be written on a matchbook cover.

Buying low book-to-value stocks, for instance, is a perenial winner on the whole. As is buying low PE stocks. As is buying stocks with a record of increasing dividends. All well-known, market-beating, strategies.

Implementing and sticking with those strategies is something else altogether, for many, many people.

Two quotations I recently posted on my site relate to fundamental reasons for market underperformance. In my view, most underperformance can be traced to poor emotional control, particularly patience. Both sayings touch on the subject ...

Most of man's troubles come from his inability to sit and be quiet for 20 minutes.

- Pascal (b. 1623, d. 1662)

A man may see straight and clearly and yet become impatient or doubtful when the market takes its time about doing as he figures it must do… the market does not beat them… they beat themselves, because even though they have brains they cannot sit tight.

- From Reminiscences of a Stock Operator, published 1923.

Most investors would do well to ponder these sayings, both before they set their strategy, and after. Just as I have, and continue to do so - to improve my performance.


JW

The Confused Capitalist

Completed labelling

I have completed back-labelling all my posts, so if you had turned off an RSS etc. feed, you now will only be getting new posts and could turn it back on without fear of a tidal wave of old postings.


JW

The Confused Capitalist

You got a problem with that?

Have your good intentions of investing perhaps turned into something else, something else you fear has become a gambling addiction?

With the rise of the internet, discount brokers and the rapid fire world we live in, it's all too easy for some investors to turn into gamblers, in the world biggest casino - the world's stock markets.

According to psychologist Paul Good, if you exhibit five of the following 11 traits, you most likely have a gambling addiction:

1. You engage in high volume trading, where "action" is more compelling than the objective of the trade;
2. You are constantly preoccupied with your investments;
3. You need to invest more and more money or increase your leverage to feel excited;
4. You have repeatedly tried to stop or control your market activity and failed;
5. You become restless and irritable when you try to cut down or stop investing;
6. You invest to escape problems, relieve depression, or distract yourself from painful emotions;
7. You sometimes have to increase your position in an investment after a loss - chasing your losses;
8. You have lied to conceal the extent of your involvement in the market;
9. You have committed an illegal act to finance your market activity;
10. You are jeopardizing significant relationships or your job because of excessive involvement in the market;
11. You have relied on others to bail you out when you got into desperate financial situations.

Tally up your score. For those who scored five or higher, why not check out a Gambler's Anonymous meeting near you?



JW

Adapted from Canadian Business.

The Confused Capitalist

ETFs - Blow your horn

I've read a few articles around the net yakking it up about how many ETFs are, essentially, replicas of other ETFs already out there. And that the 200 or so, should be enough for anyone, right? Many have really puckered up to that trumpet, and are blowing hard.

There's about 8,000 mutual funds out there, and people think that 2.5% of that in ETFs is enough? Pulleeze!

I don't hear too many financial advisor's saying that the doors should be shuttered on the 90% of mutual funds which are essentially replica's of each other AND underperform the market. Would their silence on this issue be because of the juicy trailer fees that accrue with mutual fund recommendations, and their squawking about ETFs due to the limited to no trailer fees?

Before you believe those puckered up to blow on the "200 is too many" sheet music, check their knowledge, motives and whether they're protesting the outrageous number of mutual funds.

When I see an ETF for every industry type, for every single country, for every capitalization size, and for every type of outperforming back-tested fundamental and enhanced indexing style there is, using rules-based entry strategies, and virtually every combination thereof, TIMES TWO, then I might start to agree with those already puckered up on the "there are too many" trumpet.

Until then, ETFs, until then, blow your own horn baby. Blow sweetly and with all the range of melodies available in the investment world.


JW

The Confused Capitalist

Blog Quality Continues to Impress This Blogger

Just been taking a recent tour around many new (or new to me) stocks/investing/market commentary blog sites. The quality even from so-called amateurs is amazing, as is the explosion of blogs.

It's getting hard to see all the new stuff, there's so much of it coming on so often ... all good for the consumer ... makes Jim Cramer's crap seem more like, well ... crap ...

I'll probably be adding numerous links to my site fairly soon, based on my travels to some of these great blogs ...



JW

The Confused Capitalist

The Value Blogs

There's a new blog aggregator in town, The Value Blogs. They intend to aggregate some of the best value postings from around the internet. I've already found them useful, with interesting new contributors.

You may want to take a look around there ...


JW

The Confused Capitalist

Festival of Stocks #5 - as hosted at Value Discipline

The most recent Festival of Stocks is up at Value Discipline. May I suggest you check out some of the postings and authors highlighted there?


JW

The Confused Capitalist

Informants in the investment process - rating and ranking

Separating good leads from bad is crucial in assessing investing leads. Avner Mandelman of Giraffe Capital has a method to do so.

Essentially, it's from a page stolen from spy agencies. In order to be able reliably assess information coming from a variety of informants, some sort of ranking system had to be devised.

These agencies rate their information from informants in two ways:

1. Based on the past track record of the informant, and,
2. Based on the informant's confidence in this particular piece of information.

Similarly, in assessing investing leads, whether they come from brokers, analysts, industry sources, customers, etc. we can assign a letter grade rank to each of the above. For instance, an industry source who has proved highly reliable in the past might be assigned a letter grade of "A", under point 1 above. Secondarily, they provide you with a particular piece of information that they claim they are highly certain is accurate (another "A", but under point 2, above).

This can provide you with a certain level of confidence in using this information as part of your investment process. For instance, an "A" ranked informant with an "A" piece of information would play higher in your investment process than a "B" informant, with "C" level information.

Mr. Mandelman even suggests that those so poor at any type of accuracy, can eventually become "A" level informants, by being contra-indicators. In other words, you studiously avoid their recommendations.

Of course, all of the above pre-supposes that you start tracking and rating your own informants, and keep those in your investment scrapbook. A worthwhile idea, in my view. By the way, I rate Mr. Mandelman as an "A" source.



JW

The Confused Capitalist

Moving on over to eTrade Canada

Although I've been with the Royal Bank for a long time, the new low trading fees at eTrade Canada, of $9.95 vs $28.95 is enough to cause me to move my account.

This should help me to put some more dollars in my own pocket every year. I think this (eTrades new fee schedule) is the first serious challenge to the banks oligopoly of $28-$30 fee charges on discount brokerage accounts. It'll be interesting to see what they do in a year or two from now to stem the tide of accounts leaving ...

JW

The Confused Capitalist

Proxy Investing - ETFs

Given what I believe will be phenomenal growth in ETFs over the next decade, particularly those specializing in some sort of fundamentally-based ETFs (or enhanced ETFs), would an investment in Wisdom Tree Investments (the stock) as a purveyor of fundamental ETFs be a wise proxy investment decision?

The industry probably has a huge tailwind, as ETFs generally, and fundamental ETfs in particular, begin rapidly draining money away from both mutual funds and, perhaps, to some extent, individual stocks (which themselves were often previously used as an industry proxy).

Unfortunately, there are no recent SEC filings, so by buying this pink-sheet stock, you're buying a bit of a pig in a poke. Nontheless, given the heavy hitters joing this company (Siegel, Levitt) as owners and advisors, one has to think they wouldn't want to sully their reputation on a business without a viable future. Undoubtedly, provided this stock is at a reasonable valuation now, its return will be a leveraged bet on the ETF market generally.

Value, as always however, remains the key to a decent return.

JW

The Confused Capitalist

Apologies

Apologies to anyone on an RSS etc. feed to the site, but Blogger has released a new version with the ability for tags or labels. Given that I've found their internal seach engine weak when looking for my own postings (yes, I know this is odd, but I know it's also missed postings I've done), I've decided to go back and tag all my postings, before the task becomes overwhelming.

If you're on an RSS feed you might want to turn it off for a week or so, while I do this. Otherwise, I suspect you'll be getting many repeats as I do this task.


JW

The Confused Capitalist

Fundamental Indexes & ETFs

Release the hounds! The hunt for positive alpha [or avoidance of negative alpha]).

I have just finished watching a presentation to the Toronto CFA society by Robert Arnott, Chairman of Research Affiliates. For anyone wanting a complete 60 minute education on new fundamental ETFs and indexes, I suggest that that you link up and watch the following two segments (only if you have broadband access however):

Claymore Investments 1
Claymore Investments 2

Mr. Arnott has many fascinating things to say, and many fascinating Power Point slides, all of which reinforce the superiority of fundamental indexing. For those in doubt, or those who'd just like to know more, I highly suggest this presentation.

Just one of the little nuggets he throws out there (and there are indeed, many), is that simply investing in the S&P 490 (don't invest in the 10 biggest S&P companies), would have produced an average outperformance over the S&P 500 (over the last 80 years), of about 55 to 60 basis points annually.

Even if you're a believer in the strength of fundamental indexes, as I am, there's still lots of good stuff here. Visit once, and you might be on your way to investing products from three of the larger fundamental ETF providers (Power Shares, Wisdom Tree, Claymore [USA or Canada]). Any strategy that produces 200+ basis points better annually than a conventional index, with lower risk, certainly gets my attention!

The one other fascinating thing to me, is the potential for these fundamental indexes to get a short-term boost over their usual outperformance, as more and more capital begins flowing into these companies over the next decade or so. I suspect the outperformance will be even starker over the next while, as this phenomenon unfolds.

John Bogle, thanks for the ride, but move over, the next great investment train is arriving!

JW

The Confused Capitalist

Emerging Markets

I was recently forwarded a paper written by Goldman Sachs reseachers in October 2003 relating to the potential of the BRIC emerging economies. I have written on emerging market potential outperformance many times (and here, and here too) before.

The paper projects that, given favorable growth regimes in those countries, that these economies will be one-half the size of the G6 by 2025, and larger than them, as measured in USD, by 2040. In fact, the world's largest economy in 2041 is predicted to be China.

The paper has obvious implications for any forward-looking investor. They also suggest that one expectation is that average currency appreciation for BRIC nations will be by about 2.5% annually for these currencies over the next 45 years. That's a pretty good tailwind alone, for investment results.

As the paper points out, things could obviously go wrong over that time period, but these results have reasonable potential to occur. Under the assumptions laid out in the paper (and with their model checked against history in other nations), it suggest that the largest economies in 2050 will be as follows:

1. China
2. US
3. India
4. Japan
5. Brazil
6. Russia

In other words, BRICs will have four of the top six spots. I think long-term investors should pay attention here, and try to understand why your particular investment advisor might be suggesting emerging market investment ratios of below 15% or 20% of your portfolio (which is actually below their current world GDP share in US$, at roughly 25%).

What also brought this issue into sharp relief for me, again, was a recent Economist magazine special on the world economy, that focussed on the emerging economies of the world. To an investor that wants growth at a reasonable price, these economies are growing their GDPs over the past five years at 5.6% annually, versus 1.9% for the developed world.

A forward-looking investor can't afford to ignore these reasonably-priced markets, and excellent growth prospects going forward. Are you such an investor?


JW

The Confused Capitalist