Why You’re Probably Not Earning That 8-10% “Average” Rate of Return

September 22, 2011

So far we’ve talked about ways to save money and a couple of places to put those savings. That still leaves one last question. Where can you invest those savings to get a decent return without taking too much risk?

Financial professionals love to talk about earning an average return of 8-10% in the stock market, but a lot of people I talk to are skeptical of that. It’s not just because the market hasn’t been doing well recently. It’s also that the average person hasn’t actually been earning anything close to that average return. Let’s take a look at some numbers. According to the most recent Dalbar study, the S&P 500 returned a little over 9% a year over the last 20 years, but the average investor in stocks only earned a little less than 4% a year over that same time period. Bond investors fared even worse. They earned about 1% a year compared to almost 7% a year in Barclays Aggregate Bond Index. Investors in more diversified asset allocation funds ended up in between. (If these numbers aren’t bad enough, consider that taxes and inflation could essentially eliminate that return.)

As it is, our own research shows that most employees are not on track to retire comfortably. But if you plug the returns that the average investor has actually been earning into a retirement calculator, the results would be far worse than things already look. (Keep in mind that probably about half the people are doing even worse than that average. That’s why it’s average.)

Why is this? Dalbar blames the main culprit to be people’s psychological responses to the ups and downs of the markets. I like to call it the greed, hope, and fear cycle. Here’s how it tends to work. When a market (it could be stocks, bonds, real estate, gold, etc.) has been doing really well for a while and everyone seems to be making lots of money, people want to invest more aggressively in those investments that have been doing really well recently, or that have a long track record of growth. After all, who wants to earn 8% when your neighbor is earning  more than 20%? (Remember the late 90s?)

But the market inevitably takes a fall. The reasons are always different and hard to predict. Think of the dot-com crash, the 9/11 attacks, the Enron and accounting scandals, the real estate downturn, the financial crisis of 2008, and more recently the U.S. treasury credit downgrade and worries about a debt default.

As you reflect on those moments (that you’d probably rather forget), do you remember how you felt and how you reacted? If you’re like most people, you may have waited for a little while in the hope it would turn around quickly. Depending on their personality, some people couldn’t help but look at their account balances online several times a day, while others didn’t even want to open their statements. Eventually when things got bad enough, people tended to panic, sell out, and move their money into stable value funds or cash. I can’t tell you how many people told me that they would never invest in stocks again after 2008. Most of them do get back in, but only when things have “settled down,” which usually means that the market has gone up for a while and is getting closer to another top. Rinse and repeat.

Don’t get me wrong. This is not a matter of stupidity or even lack of knowledge. I’ve personally seen this happen to all types of clients I’ve worked with, from regular middle-class folks to traders on Wall St. It’s just human nature.

The best financial advisers help their clients to resist these urges. But too often financial advisers serve more as an accomplice. It’s hard to resist giving investors want they want (aggressive investments in good time and “safe” investments in bad times) in order to earn a commission or keep a client willing to pay a nice asset management fee.

So what’s the solution? In the next few posts, I’ll explore some simple ways to overcome this problem along with some unconventional investment strategies that can possibly both reduce your risk and earn you more than even the 8-10% average returns. They’ve helped me and my former investment clients and I think they can work for you too.