Weekly Update and Blog Post
by Zach Marsh on Apr 11, 2018
Our Weekly Recap
S&P 500 -1.39%
10 Year US Treasury -0.12%
Our Weekly Reading
Benchmarks and the Trouble with Indexing Part 2
Last week we discussed some issues associated with the weightings of common market indices, notably how market cap weighting, can ultimately lead to the index being at the mercy of a small handful of companies. This creates an illusion of diversification, believing we are protected by allocating our stock investments across many holdings, but essentially over-allocated to a few select stocks or sectors. As bubbles form, our risk associated to those stocks or sectors increases. Today we wanted follow this path a bit further and discuss other dangers we encounter if we measure our retirement or goals-based investment account performance against some of these indices.
Every night on the news we are given an update on the performance of the Dow Jones Industrial Average and the S&P 500 indices. When I’m asked, “How’d the market do today?” from friends or clients, I know that what they are really asking is, “What did the Dow do today?” We’ve nearly been programmed to believe that our financial goals or retirement plans should be fastened to the performance of one of these two major indices. We know that over time being invested in the stock market has proven extremely profitable for those who stick with their investment plans. We know it is extremely difficult to time your entry and exit points from the market. But we also know that the measure of how profitable one is over any period greatly depends on timing. So, while timing the stock market is nearly impossible, timing is extremely impactful on your performance because of the volatile nature of returns.
George Clooney vs Mark Wahlberg: A Lesson in Timing
George Clooney was born in 1961, Mark Wahlberg was born in 1971, ten years separate the two. Both have gone on to have incredibly successful acting careers, as well as business adventures outside of acting. According to a quick Google search, the estimated net worth of these two is $500 million and $225 million, respectively. Interestingly enough, if instead of becoming famous actors, both had become CPA’s and began identical retirement saving’s plans when they turned 24, the net worth disparity would be roughly the same. Assuming a strategy where each of them contributes $800/month beginning when they turn 24 and invested it in the S&P 500, Mr. Clooney, at age 44, would have $487k, while Mark Wahlberg would’ve had only $306k, at the same age. A remarkable 59% outperformance for George, helping him with his Lake Cuomo villa payments, I'm sure.
The reason for this huge difference is simple: variance of returns. While the stock market is a great contributor to wealth creation, as Warren Buffett contends, it is also a great contributor to wealth differentiation. The annualized return on investment over these two periods varied greatly. For Clooney, he received a return of 7.95% annualized, while Wahlberg received 4.25%. Now, imagine if Mark Wahlberg’s retirement plan forecasted returns similar to what George Clooney received. Chances would be pretty great that we would be seeing “Daddy’s Home 3” coming to theaters pretty soon, sorry Mark.
Volatility Tax: What Lies Beneath Your Benchmark
Mark Spitznagel, a hedge fund manager at Universa Investments, refers to the difference between the average arithmetic return and the average geometric return, as Volatility Tax. To illustrate this, suppose you have the following returns for two years: year 1 down 50% and year 2 up 100%. The arithmetic return for these two years is a whopping 25% (100%-50% divided by 2). You'd take that, wouldn't you? Unfortunately, that isn’t how it comes out in the wash. If you started with $100 and lost 50% you would have $50. The following year your $50 remaining investment grew by 100%, or $50, getting you back to breakeven: your geometric average return was 0%. The difference is the cost of volatility on your returns. When saving for your retirement you are making projections about how much to save and what kind of return you need in order to get to where you want. Most of these forecasts are based upon average returns (arithmetic). How far your projections vary from reality is a function of how much volatility tax your returns have.
As an example, if you had invested $100 in the S&P 500 index in 1950, that $100 would’ve grown to $147,000 today, not too bad. That represents a geometric average annual return of 11.3%. But, calculating the arithmetic average of returns during this period was 12.69%. Compounding an average return of 12.69% over that time period would’ve projected a return on your $100 investment to be worth $337,000 today. That’s a big miscalculation. But it gets even worse if we look at more recent history.
Let’s take an example that may be closer to your heart. Assume you had $200,000 in 1999 that was earmarked for retirement. You looked at the returns of the S&P 500 for the prior 50 years and saw that the average return had been 12.68%. You wanted to retire with $2 million and planned to save an additional $10k per year. When you ran the numbers, you factored in your annual return and contributions and came up with an ending portfolio value of around $2.3 million. You were happy that you had a bit of a cushion. Some years would be good, some bad, but you thought, “That’s what the extra cushion is for.” But the reality was quite different. Instead of that investment being worth $2.3 million, it ended up being worth only $940k. Now that’s quite a difference. Instead of the hoped for 12.68% return (the 50-year prior historical average annual return) in reality you got meager 5.34%. That’s the volatility tax.
Building Better Benchmarks…cont.
It’s important to remember that we invest for a purpose. Volatility not only erodes returns, but it erodes your goals. Bench-marking your goals to volatile indices isn’t conducive to financial planning success. Next week we will look forward to some better ways to benchmark our investment and planning success.