Author Topic: AVERAGE stock market return misleading  (Read 7816 times)

Swamp Chomp

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AVERAGE stock market return misleading
« on: November 24, 2019, 07:32:47 PM »
We Mustachians put a lot of "stock" into the historical average stock market returns.  While discussing with someone from the mainstream investor world the "historical average stock market return" being in the ~8% range, they brought up a angle I had never thought of.   

Their example - Say you invest $100 in some nifty investment (pick your favorite):

- Year 1: Your investment becomes $200.  You have a 100% average return.
- Year 2: Your investment drops back down to $100.  You have a 50% average return.
- Year 3: Your investment goes back to $200.  You have a 67% average return.
- Year 4: Your investment goes back to $100.  You have a 50% average return. 

Having never considered this angle before but having put plenty of planning into place around the "~8% average historical stock market return" I felt a bit at a loss with their example that showed you could have earned a 50% average return on your investment and still have a $0 gain.  Their point is that the "averages" can hide a lot of important details and can be misleading.

Curious what kinds of replies you people will have to this...  Appreciate your input and insights.

TheHardenedInvestor

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Re: AVERAGE stock market return misleading
« Reply #1 on: November 24, 2019, 07:36:59 PM »
Itís called sequence of returns risk.

bacchi

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Re: AVERAGE stock market return misleading
« Reply #2 on: November 24, 2019, 07:38:34 PM »
Correct, volatility matters. This is why historical data is used in simulators like cfiresim.

shuffler

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Re: AVERAGE stock market return misleading
« Reply #3 on: November 24, 2019, 09:04:31 PM »

secondcor521

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Re: AVERAGE stock market return misleading
« Reply #4 on: November 24, 2019, 09:28:15 PM »
Look up AAGR vs. CAGR.

A couple hastily googled links:
https://www.investopedia.com/terms/a/aagr.asp
https://clubthrifty.com/average-stock-market-return/

^This.  And by the way, the historical averages of the US markets are generally quoted in terms of CAGR.  The thing to usually pay attention to is if it's nominal (before accounting for inflation) or real (after accounting for inflation).  Most long term averages are quoted in nominal terms.

AdrianC

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Re: AVERAGE stock market return misleading
« Reply #5 on: November 25, 2019, 05:59:39 AM »
Having never considered this angle before but having put plenty of planning into place around the "~8% average historical stock market return...
Why 8%?

Mess around with this:
https://dqydj.com/sp-500-return-calculator/

Real return (after inflation):
1871 - now 6.9% (total data set)
1998 - now 4.5% (my investing career)

IMHO, a lumpy 4.5% real is a reasonable return expectation for stocks, perhaps a little optimistic. Deduct for cash and bond holdings - expect 0% for them.

vand

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Re: AVERAGE stock market return misleading
« Reply #6 on: November 26, 2019, 02:25:34 AM »
In the Investment Performance industry this is referred to as Arithmetric return vs Geometric return. In fact, there are several ways and much debate about how "return" should be calculated, though most agree that geometric is the most accurate method. For a money manager, when they also have to start accounting for cashflows it gets quite complicated quite quickly (let's say the market went up 20% last year.. all fine and good, except if you added/withdrew at any point during the year then you can't just use the 20% number as the performance from the point of the cashflow is important, ditto for how to handle inreinvested dividend & interest).
« Last Edit: November 26, 2019, 02:38:36 AM by vand »

DadJokes

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Re: AVERAGE stock market return misleading
« Reply #7 on: November 26, 2019, 06:02:30 AM »
Most people talk in terms of annualized returns (CAGR), not average returns (AAGR).

bigblock440

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Re: AVERAGE stock market return misleading
« Reply #8 on: November 27, 2019, 02:31:47 PM »
Quote
- Year 2: Your investment drops back down to $100.  You have a 50% average return.

I'm confused, how do you have a 50% return when your value is cut in half?  A 50% return on $200 would be an additional $100, bringing your portfolio value up to $300, would it not?

Mr. Green

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Re: AVERAGE stock market return misleading
« Reply #9 on: November 27, 2019, 02:58:30 PM »
I also am confused by the math here. When I think average return I think price Delta divided by time. The same $100 4 years later sounds like a 0% return to me.

SeattleCPA

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Re: AVERAGE stock market return misleading
« Reply #10 on: November 27, 2019, 03:41:05 PM »
+1 to @vand ... and @secondcor521 ... and @DadJokes ... and @shuffler  and @bacchi .


SwordGuy

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Re: AVERAGE stock market return misleading
« Reply #11 on: November 27, 2019, 05:54:16 PM »

You don't average averages.  That's bad math.   You can calculate returns from one starting point to an ending point, but averaging the returns is for each year doesn't provide meaningful results.   

At least, that's the math I remember from high school.   I'm sure I'll hear differently if I've remembered wrong. :)

jeroly

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Re: AVERAGE stock market return misleading
« Reply #12 on: November 27, 2019, 06:09:53 PM »
We Mustachians put a lot of "stock" into the historical average stock market returns.  While discussing with someone from the mainstream investor world the "historical average stock market return" being in the ~8% range, they brought up a angle I had never thought of.   

Their example - Say you invest $100 in some nifty investment (pick your favorite):

- Year 1: Your investment becomes $200.  You have a 100% average return.
- Year 2: Your investment drops back down to $100.  You have a 50% average return.
- Year 3: Your investment goes back to $200.  You have a 67% average return.
- Year 4: Your investment goes back to $100.  You have a 50% average return. 

Having never considered this angle before but having put plenty of planning into place around the "~8% average historical stock market return" I felt a bit at a loss with their example that showed you could have earned a 50% average return on your investment and still have a $0 gain.  Their point is that the "averages" can hide a lot of important details and can be misleading.

Curious what kinds of replies you people will have to this...  Appreciate your input and insights.

https://www.investopedia.com/ask/answers/06/geometricmean.asp

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #13 on: November 30, 2019, 05:34:09 PM »
Quote
- Year 2: Your investment drops back down to $100.  You have a 50% average return.

I'm confused, how do you have a 50% return when your value is cut in half?  A 50% return on $200 would be an additional $100, bringing your portfolio value up to $300, would it not?

100% gain year one, plus 0% gain year two, divided by 2 years gives you 50% avg.

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #14 on: November 30, 2019, 05:59:15 PM »
Thanks all for the tips on the different ways to calculate the averages.  Super helpful.

What is confusing is why MMM himself refers to a 7% average annual return in his examples ("On average, if the stock market continues its historical performance, your investments will return close to 7% per year even after keeping up with inflation." < Taken from: https://www.mrmoneymustache.com/2011/06/06/dude-wheres-my-7-investment-return/).

So which of these averages is he using?  CAGR, AAGR, Geometric Mean...? 

And more importantly, from what has been discussed in this thread, it sounds like that is a terrible way to play out the potential returns one could expect to see from long-term investment into stocks, namely the coveted VTSAX, right?

DadJokes

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Re: AVERAGE stock market return misleading
« Reply #15 on: December 01, 2019, 08:20:24 AM »
Thanks all for the tips on the different ways to calculate the averages.  Super helpful.

What is confusing is why MMM himself refers to a 7% average annual return in his examples ("On average, if the stock market continues its historical performance, your investments will return close to 7% per year even after keeping up with inflation." < Taken from: https://www.mrmoneymustache.com/2011/06/06/dude-wheres-my-7-investment-return/).

So which of these averages is he using?  CAGR, AAGR, Geometric Mean...? 

And more importantly, from what has been discussed in this thread, it sounds like that is a terrible way to play out the potential returns one could expect to see from long-term investment into stocks, namely the coveted VTSAX, right?

I would assume that he is using CAGR. The number you come up with varies based on what year you set as the baseline. For example, if I set 1939 as the first year (80 year window), the inflation-adjusted annualized return (with dividends reinvested) of the S&P 500 is 6.97%.

When you are investing for the long term, there isn't really a better way to estimate returns than historical average. We have to plan for bad years, which is why the 4% rule is a good rule of thumb to use for safe withdrawal rates.

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #16 on: December 01, 2019, 06:54:49 PM »
@DadJokes, so when playing out investment scenarios/options for ones self, how do I know what percentage to use?  You're referring to a very long investment window to show a 6.97%, whereas @AdrianC is referencing a 4.5%...  Fear I'm getting turned around a bit here...

the_gastropod

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Re: AVERAGE stock market return misleading
« Reply #17 on: December 01, 2019, 07:01:09 PM »
@DadJokes, so when playing out investment scenarios/options for ones self, how do I know what percentage to use?  You're referring to a very long investment window to show a 6.97%, whereas @AdrianC is referencing a 4.5%...  Fear I'm getting turned around a bit here...

AdrianC referenced their investment career, which began near a market peak in 1998. Even with that unfortunate timing, the market has returned 4.5% each year on average. That's not too shabby. On a longer time horizon, (e.g., starting in the early 1900s), you'll see a CAGR of ~7%.

Nobody can tell you what percentage to use, since none of us can predict the future. But there's a good deal of history that suggests a 4% withdrawal rate is very safe.
« Last Edit: December 01, 2019, 07:03:20 PM by the_gastropod »

ysette9

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Re: AVERAGE stock market return misleading
« Reply #18 on: December 02, 2019, 03:00:26 AM »
You are also mixing up inflation adjusted and nominal returns which will be off from each other around 3%.

ysette9

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Re: AVERAGE stock market return misleading
« Reply #19 on: December 02, 2019, 03:01:05 AM »
Quote
- Year 2: Your investment drops back down to $100.  You have a 50% average return.

I'm confused, how do you have a 50% return when your value is cut in half?  A 50% return on $200 would be an additional $100, bringing your portfolio value up to $300, would it not?

100% gain year one, plus 0% gain year two, divided by 2 years gives you 50% avg.
This is averaging averages which is bad math, as mentioned above.

Frankies Girl

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Re: AVERAGE stock market return misleading
« Reply #20 on: December 02, 2019, 03:34:00 AM »
Thanks for the explanation as I just attended a "free" financial dinner where the adviser used a 4 year example very similar to the one posted by OP, and while I knew it was calculated wrong (on purpose to push his agenda) I was not familiar with geometric mean/definition.

One of the sneaky ways these jerks manipulate the facts. He kept stating throughout "do the math" and "numbers don't lie" but as clearly demonstrated, it's super easy to make them say whatever you'd like.

vand

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Re: AVERAGE stock market return misleading
« Reply #21 on: December 02, 2019, 07:30:09 AM »
You may also want to invest some time into making sure you   understand the difference between time-weighted return and dollar-weighted return.

From an FI perspective, you could make a strong argument that what matters most is your dollar-weighted return. I mean, do you really care if the market returned a lousy figure if you have a 70% saving rate and therefore your portfolio grew substantially just from contributions alone? Likewise, sellar returns aren't really going to help you much if you have sod all invested.

To the professional money management industry the time-weighted return is utterly crucial because it forms the basis of like for like comparison, but on an individual level where we are largely in control of out cashflows in/out of our own portfolios we should be placing far more emphasis on the actual size of our pots, ie dollar weighted.

AdrianC

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Re: AVERAGE stock market return misleading
« Reply #22 on: December 02, 2019, 07:41:24 AM »
@DadJokes, so when playing out investment scenarios/options for ones self, how do I know what percentage to use?  You're referring to a very long investment window to show a 6.97%, whereas @AdrianC is referencing a 4.5%...  Fear I'm getting turned around a bit here...

That's why I said you should mess around with this:
https://dqydj.com/sp-500-return-calculator/

Get a feel for past returns.
Annualized S&P 500 Return (Dividends Reinvested) adjusted for inflation (November - November):
1966 - 1986 3.628%
1986 - now 7.550%
1966 - now 6.053% (an important period for me...)
1998 - now 4.512% (my investing career)
1998 - 2008 -3.491% (my first 10 years investing)
2008 - now 12.362% (current bull market)

Note that I've done better than the 4.5% of my investing career because I've invested when I could, a lot of it during that first, "lost" decade.

What will we see the next 20 or 30 years? No way to know.

As the_gastropod wrote, "none of us can predict the future. But there's a good deal of history that suggests a 4% withdrawal rate is very safe."

theoverlook

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Re: AVERAGE stock market return misleading
« Reply #23 on: December 16, 2019, 01:04:08 PM »

100% gain year one, plus 0% gain year two, divided by 2 years gives you 50% avg.
Going from 200 to 100 is not a 0% gain. It's a loss, or negative return. So your "mainstream investor world" friend made a basic math error.

EliteZags

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Re: AVERAGE stock market return misleading
« Reply #24 on: December 16, 2019, 03:06:18 PM »
^
|
exactly

Quote
- Year 2: Your investment drops back down to $100.  You have a 50% average return.

I'm confused, how do you have a 50% return when your value is cut in half?  A 50% return on $200 would be an additional $100, bringing your portfolio value up to $300, would it not?

100% gain year one, plus 0% gain year two, divided by 2 years gives you 50% avg.


Quote
- Year 2: Your investment drops back down to $100.  You have a 50% average return.


a 0% gain in year two would mean you're still at $200, not going back down to $100
« Last Edit: December 16, 2019, 03:10:26 PM by EliteZags »

Scortius

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Re: AVERAGE stock market return misleading
« Reply #25 on: December 16, 2019, 04:53:26 PM »
If it helps... for any process that moves exponentially (or geometrically), you can remap the values onto a logarithmic scale. This linearizes the process and allows you to think about it more naturally.

To transform the series, simply convert all values to the log of that value. The base of the log doesn't matter, so you can use the natural log (ln) or a base ten log (sometimes log, sometimes log10).

If the value of your stock starts at 100, then increases to 200, then drops back down to 100, that's a percentage change of +100% and -50% for an 'average gain' of 25% and a net result of zero. Very confusing.

But, let's take the natural log of those values. The stock starts at 4.6, it increases to 5.3, and then decreases back to 4.6. In log-space, you don't multiply, you add. So the stock went up 0.7 'nats' and then back down 0.7 'nats' for an average change of 0.

Now we're in units of 'nats'. How the hell is this any more helpful? Well, it lets us calculate back to our normal units and we can get the true average return very easily.

Our stock started out at $100. Ten years later it's worth $750. What's the average return?

1) Convert to nats: Stock went from 4.6 to 6.6 in ten years. That's an average change of 0.2 nats per year.

2) Convert back: the exp() function is the inverse of the natural log. e^0.2 = about 1.221. Your stock averaged a 22.1% gain each year.

This answer will hold no matter what the intermediate values are between where you started and stopped, so you can skip the middle, or you can average the logarithmic values as you are trying to do with the percentage changes.

$100 * 1.221^10 is about $750.

« Last Edit: December 16, 2019, 04:57:00 PM by Scortius »

norajean

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Re: AVERAGE stock market return misleading
« Reply #26 on: December 16, 2019, 05:05:56 PM »

That's why I said you should mess around with this:
https://dqydj.com/sp-500-return-calculator/

Get a feel for past returns.
Annualized S&P 500 Return (Dividends Reinvested) adjusted for inflation (November - November):
..
2008 - now 12.362% (current bull market)

1929-1951 -  negative 2%.   

If we get another Depression everyone will be underwater for a couple decades, starting off with a precipitous 60% drop.

YoungInvestor

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Re: AVERAGE stock market return misleading
« Reply #27 on: December 16, 2019, 06:18:36 PM »
When looking at exponential things, using a geometric average is generally far better. This is what is done to calculate CAGR. It can easily be done by using Bt, Balance at time t, B0, Balance at the start and doing (Bt/B0)^(1/t)

I'm just curious: did you think there was this gaping hole in personal finance that nobody had noticed?

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #28 on: December 16, 2019, 06:21:22 PM »
If it helps... for any process that moves exponentially (or geometrically), you can remap the values onto a logarithmic scale. This linearizes the process and allows you to think about it more naturally.

To transform the series, simply convert all values to the log of that value. The base of the log doesn't matter, so you can use the natural log (ln) or a base ten log (sometimes log, sometimes log10).

If the value of your stock starts at 100, then increases to 200, then drops back down to 100, that's a percentage change of +100% and -50% for an 'average gain' of 25% and a net result of zero. Very confusing.

But, let's take the natural log of those values. The stock starts at 4.6, it increases to 5.3, and then decreases back to 4.6. In log-space, you don't multiply, you add. So the stock went up 0.7 'nats' and then back down 0.7 'nats' for an average change of 0.

Now we're in units of 'nats'. How the hell is this any more helpful? Well, it lets us calculate back to our normal units and we can get the true average return very easily.

Our stock started out at $100. Ten years later it's worth $750. What's the average return?

1) Convert to nats: Stock went from 4.6 to 6.6 in ten years. That's an average change of 0.2 nats per year.

2) Convert back: the exp() function is the inverse of the natural log. e^0.2 = about 1.221. Your stock averaged a 22.1% gain each year.

This answer will hold no matter what the intermediate values are between where you started and stopped, so you can skip the middle, or you can average the logarithmic values as you are trying to do with the percentage changes.

$100 * 1.221^10 is about $750.


You lost me big time here bud.  But thanks for trying... my IQ/education just can't keep up here :)

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #29 on: December 16, 2019, 06:29:24 PM »
When looking at exponential things, using a geometric average is generally far better. This is what is done to calculate CAGR. It can easily be done by using Bt, Balance at time t, B0, Balance at the start and doing (Bt/B0)^(1/t)

I'm just curious: did you think there was this gaping hole in personal finance that nobody had noticed?

No, I figured it was a gap in my own knowledge, which we've positively confirm to be true.  This has been a good dialogue, I'm just not sure that it has brought forth much clarity.  I'm still left wondering why MMM, ChooseFI, and many others encourage readers/listeners to make plans based on a 7% long-term return.

For my personal situation, I've done a cash-out refi going from a 4.99% on a $142K mortgage to a 3.75% on a $175K loan with $30K cash at closing.  My initial plan was to invest the chunk, again, jumping on the train of thought that a approx. 7% return in the long-term would be the way to go and more than cancel out the interest.  The more I look into this however, the more I question it.  This OP was the thing that this financial pro shared that initially made me question the touted 7% average long-term stock market return...

RWD

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Re: AVERAGE stock market return misleading
« Reply #30 on: December 16, 2019, 06:48:49 PM »
I'm still left wondering why MMM, ChooseFI, and many others encourage readers/listeners to make plans based on a 7% long-term return.

You have to make estimates off of something. Might as well choose the historical real return. Of course the future is unknown and plans will need to be flexible.

I should note here that expecting a 7% return is different than relying on 7%. The 4% rule doesn't come from assuming a 7% return. It was determined by looking at the entire history of the stock market and finding the worst time periods and seeing what withdrawal rate would survive.

Radagast

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Re: AVERAGE stock market return misleading
« Reply #31 on: December 16, 2019, 08:10:07 PM »
You may also want to invest some time into making sure you   understand the difference between time-weighted return and dollar-weighted return.

From an FI perspective, you could make a strong argument that what matters most is your dollar-weighted return. I mean, do you really care if the market returned a lousy figure if you have a 70% saving rate and therefore your portfolio grew substantially just from contributions alone? Likewise, sellar returns aren't really going to help you much if you have sod all invested.

To the professional money management industry the time-weighted return is utterly crucial because it forms the basis of like for like comparison, but on an individual level where we are largely in control of out cashflows in/out of our own portfolios we should be placing far more emphasis on the actual size of our pots, ie dollar weighted.
We seem to mostly be in agreement these days. I strongly agree with that statement. Time weighted vs money weighted makes a potentially large difference for high saving rates and high withdrawal rates, but many/most just use time weighted and gloss over sequence of returns gains and losses.


That's why I said you should mess around with this:
https://dqydj.com/sp-500-return-calculator/

Get a feel for past returns.
Annualized S&P 500 Return (Dividends Reinvested) adjusted for inflation (November - November):
..
2008 - now 12.362% (current bull market)

1929-1951 -  negative 2%.   

If we get another Depression everyone will be underwater for a couple decades, starting off with a precipitous 60% drop.
The correct answer is +3%. You ignored dividends. You could argue that people back then didn't reinvest because it was too much work, but with a 5% dividend I bet they were still feeling pretty OK if they had 25% in cash/bonds and didn't sell stocks at the bottom.

shinn497

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Re: AVERAGE stock market return misleading
« Reply #32 on: December 17, 2019, 09:59:08 AM »
This is why it is important to understand the difference between time weighted returns, money weighted returns,  and internal rates of return.

Most investment returns are time weighted, as that is agnostic to investor behaviour. Technically dividend reivestment is investor behaviour so they are left out. But it is worth considering them.
Betterment wrote a great article about his, that I suggest checking out.


On a side note. When you calculate or consider returns, you should think about the exact purpose. Returns mean nothing without being factored into an investment strategy. This is why I do most of my planning by modeling, with monte carlo simulations, accumulation and withdrawal. With that method, there is no specific return.
« Last Edit: December 17, 2019, 10:04:28 AM by shinn497 »

Leisured

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Re: AVERAGE stock market return misleading
« Reply #33 on: December 19, 2019, 05:33:25 AM »
Investment is like a roller coaster in reverse. A roller coaster starts high, goes down, then up, then down again, but ends at a lesser height because of wind and wheel resistance.

Stock investment starts low and grows over time. There will be exhilarating highs, crestfallen lows, but what matter is when the stock reaches a point higher than you bought at. The rule of thumb is 7% growth a year, which is a doubling every decade. This is what matters, not the roller coaster highs and lows. Ask Warren Buffet.


theoverlook

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Re: AVERAGE stock market return misleading
« Reply #34 on: December 19, 2019, 09:15:23 AM »

No, I figured it was a gap in my own knowledge, which we've positively confirm to be true.  This has been a good dialogue, I'm just not sure that it has brought forth much clarity.  I'm still left wondering why MMM, ChooseFI, and many others encourage readers/listeners to make plans based on a 7% long-term return.

For my personal situation, I've done a cash-out refi going from a 4.99% on a $142K mortgage to a 3.75% on a $175K loan with $30K cash at closing.  My initial plan was to invest the chunk, again, jumping on the train of thought that a approx. 7% return in the long-term would be the way to go and more than cancel out the interest.  The more I look into this however, the more I question it.  This OP was the thing that this financial pro shared that initially made me question the touted 7% average long-term stock market return...
MMM and others encourage you to estimate a 7% long term return because that is the real return we have historically seen from the stock market as a whole. You can plan on it being around there, as long as you have a long enough window. You might lose some over a short time span, but a long enough time span should average out to around 7% after inflation. And a real average, not your "financial pro's" mistaken average. It's possible we'll see lower returns in the future, but it's also possible we'll see higher or that the dollar will cease to exist or that portals to 1300 worlds will open up and spark a new gold rush. The only real tools we have to plan for the future involve looking at the past and making reasonable extrapolations.

As to why he made that error, you didn't mention previously that he was a financial pro. Given that information, I have a good guess as to why he made that "error:" He is trying to sell you something. Given that, it's to his advantage to have you confused and questioning the information you learn here or from other financial independence websites. Keep in mind, MMM isn't selling anything (other than affiliate links for credit cards and advertising). He doesn't make a penny even if you buy a million shares of VTSAX. He's got biases like any of us, but he doesn't have the same motivations as a "financial pro" that stands to make a fat commission on your money - actually a commission paid for with your money. Those guys will say almost anything to keep you confused and doubtful because that's how they make money.

That said, I think doing a cash-out refi of your residence to invest the money is a terrible idea. Since you've already done the cash-out refi part you have to decide what to do from there. I haven't taken any steps to pay off my mortgage early but I'm also not going to take out any equity as that's how you end up over-leveraged going into a downturn. What do you owe on your house now, with the cash-out refi, and what is the appraised value?

nereo

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Re: AVERAGE stock market return misleading
« Reply #35 on: December 19, 2019, 10:18:36 AM »
=

1929-1951 -  negative 2%.   

If we get another Depression everyone will be underwater for a couple decades, starting off with a precipitous 60% drop.

Nope.  It's +3.8% real returns (dividends reinvested).  Not too shabby give this is cherry-picking the worst financial collapse as the start date, and almost no one lump-sum invests their entire portfolio in one go (typically you may contributions over many years as cashflow allows). 

If you had started investing in the early 1920s your portfolio would be in positive territory by 1940 despite the mother of all stock market drops.
oops - i see @Radagast beat me to the punch here...

robartsd

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Re: AVERAGE stock market return misleading
« Reply #36 on: December 19, 2019, 11:07:39 AM »
MMM and others encourage you to estimate a 7% long term return because that is the real return we have historically seen from the stock market as a whole. You can plan on it being around there, as long as you have a long enough window. You might lose some over a short time span, but a long enough time span should average out to around 7% after inflation. And a real average, not your "financial pro's" mistaken average.

I'm personally convinced that 7% is a bit overly optimistic for long term real returns. I think part of this is due to stock investing becoming more accessible. The increased demand for passive stock market income may have permanently pushed up the price of future earnings in recent decades. For my own projections I tend to use 6% long term average real returns (5% if I'm feeling pessimistic or want slightly easier math).

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Re: AVERAGE stock market return misleading
« Reply #37 on: December 19, 2019, 12:40:45 PM »
Someone investing in 2000 as a lump sum investment only saw paltry gains (investing at the top will do that).  Someone making regular investments (dollar cost averaging effectively) since 2000 saw much better returns, as a lot of money was invested at through the trough of the recession when prices were discounted heavily.  You effectively smear out the peaks and valleys.

Over my working career from summer 1998 until today equal investments (growing with inflation) would average an effective 9.1% growth rate despite starting with a bubble at the beginning.  Had it been a single lump sum at the same starting point it would have been 6.8%.  Chop off about 2.3% from both if you want to factor in inflation to get to real terms.

These are all just tools, and you can easily manipulate them to support whatever bias you have (or want to have).  All the "experts" have predicted much lower returns for the next decade, just like they did for the last decade.  Whatever.  Recessions will come.  Bubbles will pop.  Returns from stocks will still likely greatly outpace other options over a sufficiently long time span.

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Re: AVERAGE stock market return misleading
« Reply #38 on: December 21, 2019, 12:33:53 PM »
This is why it is important to understand the difference between time weighted returns, money weighted returns,  and internal rates of return.

Most investment returns are time weighted, as that is agnostic to investor behaviour. Technically dividend reivestment is investor behaviour so they are left out. But it is worth considering them.
Betterment wrote a great article about his, that I suggest checking out.


On a side note. When you calculate or consider returns, you should think about the exact purpose. Returns mean nothing without being factored into an investment strategy. This is why I do most of my planning by modeling, with monte carlo simulations, accumulation and withdrawal. With that method, there is no specific return.

Thanks for the article - really helpful!

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #39 on: December 21, 2019, 12:53:03 PM »

No, I figured it was a gap in my own knowledge, which we've positively confirm to be true.  This has been a good dialogue, I'm just not sure that it has brought forth much clarity.  I'm still left wondering why MMM, ChooseFI, and many others encourage readers/listeners to make plans based on a 7% long-term return.

For my personal situation, I've done a cash-out refi going from a 4.99% on a $142K mortgage to a 3.75% on a $175K loan with $30K cash at closing.  My initial plan was to invest the chunk, again, jumping on the train of thought that a approx. 7% return in the long-term would be the way to go and more than cancel out the interest.  The more I look into this however, the more I question it.  This OP was the thing that this financial pro shared that initially made me question the touted 7% average long-term stock market return...
MMM and others encourage you to estimate a 7% long term return because that is the real return we have historically seen from the stock market as a whole. You can plan on it being around there, as long as you have a long enough window. You might lose some over a short time span, but a long enough time span should average out to around 7% after inflation. And a real average, not your "financial pro's" mistaken average. It's possible we'll see lower returns in the future, but it's also possible we'll see higher or that the dollar will cease to exist or that portals to 1300 worlds will open up and spark a new gold rush. The only real tools we have to plan for the future involve looking at the past and making reasonable extrapolations.

As to why he made that error, you didn't mention previously that he was a financial pro. Given that information, I have a good guess as to why he made that "error:" He is trying to sell you something. Given that, it's to his advantage to have you confused and questioning the information you learn here or from other financial independence websites. Keep in mind, MMM isn't selling anything (other than affiliate links for credit cards and advertising). He doesn't make a penny even if you buy a million shares of VTSAX. He's got biases like any of us, but he doesn't have the same motivations as a "financial pro" that stands to make a fat commission on your money - actually a commission paid for with your money. Those guys will say almost anything to keep you confused and doubtful because that's how they make money.

That said, I think doing a cash-out refi of your residence to invest the money is a terrible idea. Since you've already done the cash-out refi part you have to decide what to do from there. I haven't taken any steps to pay off my mortgage early but I'm also not going to take out any equity as that's how you end up over-leveraged going into a downturn. What do you owe on your house now, with the cash-out refi, and what is the appraised value?


Well, what the heck, guess you can't trust people...  His concern was also that I was investing with borrowed money and that led to him giving me this example in the OP.  So, maybe not totally untrustworthy.

The reason we did the cash-out refi was essentially because of this 7% talk.  We had the option to lower our rate from 4.99 to 3.75 and we could either:

- Option 1:  reduce our monthly payment by $115/month, which we would have then invested  -- OR --
- Option 2:  get $30,000 cash at the aforementioned rate and then invest

Factoring these two scenarios, assuming 7% avg. return annually over a 20-year timeline looked like:

- Option 1:  $56,573.78
- Option 2:  $116,090.53

So, we opted for Option 2.  What am I missing?

Regarding your questions about the house, the mortgage is for $170,000.  Appraised value is $320,000. 

... Looking forward to your reply - Thank you!

Telecaster

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Re: AVERAGE stock market return misleading
« Reply #40 on: December 21, 2019, 02:51:08 PM »
The reason we did the cash-out refi was essentially because of this 7% talk.  We had the option to lower our rate from 4.99 to 3.75 and we could either:

- Option 1:  reduce our monthly payment by $115/month, which we would have then invested  -- OR --
- Option 2:  get $30,000 cash at the aforementioned rate and then invest

Factoring these two scenarios, assuming 7% avg. return annually over a 20-year timeline looked like:

- Option 1:  $56,573.78
- Option 2:  $116,090.53

So, we opted for Option 2.  What am I missing?


On paper it works.  However, there have been 20 year periods when the real S&P 500 has returned less than your mortgage rate.   So it is not a slam dunk if we use history as guide.    However,   most of the time it would have worked, and some of the time it would have been a home run.   

AdrianC

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Re: AVERAGE stock market return misleading
« Reply #41 on: December 23, 2019, 06:48:50 AM »
Factoring these two scenarios, assuming 7% avg. return annually over a 20-year timeline looked like:

- Option 1:  $56,573.78
- Option 2:  $116,090.53

So, we opted for Option 2.  What am I missing?

In 20 years time that extra $60k you *might* have will be such a tiny part of your net worth that you'll wonder why you worried about it in the first place.

Having a mortgage is fine. Refi to a lower rate is wonderful. A cash out refi to invest in stocks at an historically high valuation? That isn't something I'd do, but it won't matter much in the long run.

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Re: AVERAGE stock market return misleading
« Reply #42 on: December 23, 2019, 06:45:07 PM »
The reason we did the cash-out refi was essentially because of this 7% talk.  We had the option to lower our rate from 4.99 to 3.75 and we could either:

- Option 1:  reduce our monthly payment by $115/month, which we would have then invested  -- OR --
- Option 2:  get $30,000 cash at the aforementioned rate and then invest

Factoring these two scenarios, assuming 7% avg. return annually over a 20-year timeline looked like:

- Option 1:  $56,573.78
- Option 2:  $116,090.53

So, we opted for Option 2.  What am I missing?


On paper it works.  However, there have been 20 year periods when the real S&P 500 has returned less than your mortgage rate.   So it is not a slam dunk if we use history as guide.    However,   most of the time it would have worked, and some of the time it would have been a home run.


Okay, so can you see why I'm getting confused about using the 7% historical average in guiding decisions? 

So what *would* you guys do now?  Put the $30K back on the mortgage?

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Re: AVERAGE stock market return misleading
« Reply #43 on: December 23, 2019, 07:41:07 PM »

Okay, so can you see why I'm getting confused about using the 7% historical average in guiding decisions? 

So what *would* you guys do now?  Put the $30K back on the mortgage?

I definitely would not put it back on at this point.  The median and mean 20-year return are both about 7%.   The high is 13.5% and the low is zero.   But those are inflation adjusted returns.  To compare apples to apples,  you have inflation adjust your mortgage too.   The average long term inflation rate is 3.5% or something close to that.  So you mortgage cost might not be a whole lot more than zero.   

nereo

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Re: AVERAGE stock market return misleading
« Reply #44 on: December 24, 2019, 05:03:23 AM »
Quote
So what *would* you guys do now?  Put the $30K back on the mortgage?

I would definitely NOT put it back on the mortgage.  The reason is because there are (probably) much better vehicles for your money.  If you have any tax-advantaged space left (e.g. 401(k)/403(b) and IRA) I would fully fund those first. Since it is the end of the year you *might* still have to contribute more to your workplace retirement accounts before the end of the year.  For IRAs you have until April 2020 to fund 2019.

If those are maxed out I would just put it into my regular investments.  As mentioned you need to reduce the value of your mortgage by inflation too.  Donít worry about current valuations - worry about time in the market.

Swamp Chomp

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Re: AVERAGE stock market return misleading
« Reply #45 on: December 27, 2019, 11:50:15 AM »
Quote
So what *would* you guys do now?  Put the $30K back on the mortgage?

I would definitely NOT put it back on the mortgage.  The reason is because there are (probably) much better vehicles for your money.  If you have any tax-advantaged space left (e.g. 401(k)/403(b) and IRA) I would fully fund those first. Since it is the end of the year you *might* still have to contribute more to your workplace retirement accounts before the end of the year.  For IRAs you have until April 2020 to fund 2019.

If those are maxed out I would just put it into my regular investments.  As mentioned you need to reduce the value of your mortgage by inflation too.  Donít worry about current valuations - worry about time in the market.

10-4.  I'm self-employed and don't have a 401k or 403b, so just IRAs, which are maxed out for both my wife and I just year

(Side question: if we fund an IRA between Jan-April, does that automatically go toward the prior tax year?  So in order to fund 2020, we would need to fund after April?)

When you say "regular investments" do you mean your taxable/brokerage account?  Or do you use a life insurance policy or something else as another vehicle?

Greatly appreciate it @nereo & @Telecaster!

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Re: AVERAGE stock market return misleading
« Reply #46 on: December 27, 2019, 11:59:53 AM »

(Side question: if we fund an IRA between Jan-April, does that automatically go toward the prior tax year?  So in order to fund 2020, we would need to fund after April?)

You can do either.  Beginning Jan 1 you can fund your 2020 IRAs. 
If you have not yet maxed out your 2019 IRAs, you have until April 15, 2020.  You indicated that you already have maxed out your IRAs for 2019, so I'd just start contributing to your 2020 IRAs in January.  Your brokerage (e.g. Vanguard or Fidelity or...) will let you select which tax year you are contributing toward.

Also - as you are self employed you may want to look into setting up your own Solo-directed 401(k).  this can allow you to get the tax-advantaged benefits of a normal 401(k). 


Quote
When you say "regular investments" do you mean your taxable/brokerage account?  Or do you use a life insurance policy or something else as another vehicle?
invest according to your Investment Policy Statement (IPS) or Asset Allocation (AA) outlines.  If you don't have either, you should (it's easy!).  For most people this will mean putting money into a taxable brokerage account such as a broad-market index fund.  For others it may be investing in real estate or your own business or beanie babies.  I would only recommend a broad-market fund for strangers over the internet.  Real estate can be great, but it requires a much deeper pool of knowledge than you are going to get from this thread.

Telecaster

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Re: AVERAGE stock market return misleading
« Reply #47 on: December 27, 2019, 12:10:40 PM »

10-4.  I'm self-employed and don't have a 401k or 403b, so just IRAs, which are maxed out for both my wife and I just year

Ah! But you can!  There is such a thing a self-employed 401(K)

https://www.fidelity.com/retirement-ira/small-business/self-employed-401k/overview

You can put up to $19,000 away as an "employee" contribution (under age 55), PLUS an additional 25% from your "employer" contribution, up  $56,000.   If your income is high enough, you could stuff that whole $30K into retirement.    Hurry though!   You must set up the plan before December 31, 2019.   

OR, you can  open SEP-IRA which allows 25% of profit.  So similar to the SE 401(k) but without "employee" contribution.   You have until April 15, 2020 to open and fund the SEP IRA for tax year 2019.   

Quote
(Side question: if we fund an IRA between Jan-April, does that automatically go toward the prior tax year?  So in order to fund 2020, we would need to fund after April?)

No, you can start funding your 2020 IRA in January 2020.   It is your responsibility to keep track of which dollars are contributed for which tax year.   

 

Wow, a phone plan for fifteen bucks!