Forget your quarterly report. Think long-term and real return.
by Doyle Ranstrom on Apr 5, 2021
Let's say you make an investment into a stock or stock fund buying shares at $10 per share. After you buy it, let's assume the following happens:
- The share price declines to $7 per share.
- Then it recovers back up to $10 a share.
- Then it increases to $12 a share.
- From there it declines down to $9 per share.
- And finally, it increases to $15 per share at which point you sold it.
Here is the question, how much did you lose when it first declined to $7 per share. Take your time, this is a trick question.
Well, the obvious answer is you did not lose any money when the share price declined to $7 per share, The reason is you did not sell. So in reality, it did not matter that the share price declined to $7 which for the record, was a 30% decline in market value. Because you are a smart investor with a long-term time horizon along with specific investment objectives, you did not panic and ultimately had a realized return of 50%.
Sadly, however, many investors are not as smart as you. There are reasons why multiple studies show the average investor consistently underperforms the stock market average as measured by major stock market indexes. One reason is many investors looking at a quarterly report and seeing a decline, think they are losing money, sell the shares turning a paper decline into a realized loss.
At this time, investors have been receiving their quarterly investment reports. Since various equity asset classes have generally increased in market value year to date, investors may take a quick glance and move on. Understandable, but I would suggest now is a good time to think about the future, especially the long-term future.
For a lot of reasons, I believe we are in a new normal. Over the next few weeks and months, I will be commenting on various aspects of what I believe will be important financial factors going forward. Who knows if I will be right or not. There is a reason that every disclaimer says "there are no guarantees for the future" or "past performance does not predict future results". At the same time, regardless if you are a current retiree, or hope to be a future retiree, it makes sense, in fact, is essential, to spend time thinking about your your-long financial future.
Let me give you one example. Many investors along with financial advisors believe inflation rates will stay low. And maybe they are correct, but personally, I am not so sure. The average inflation rate in the past decade was 1.76%. The previous decade, 2000-2009, it was 2.90%. However, people in my age range will remember inflation rates were much higher for a long period of time. In the 1970s the average inflation rate was 6.61% and in the 1980s it was 5.59%. So for two decades, the average inflation rate was about 6%.
Is this important? I would suggest it is a very important financial assumption to consider. For example, let's assume for the next decade inflation averages 3%. That means if you have $10,000 today which you wish to invest for the next ten years, you will need that $10,000 to grow to $13,439. If over the ten years, the average return on your investment is 3%, you have essentially broken even. Your $10,000 has maintained its buying power.
However, let's say the inflation rate is 5% over the next decade. Now you will need your $10,000 to grow to $16,289 to have the same buying power. If you have an average rate o return of 3%, you may feel good that the value of the account increased, the reality is you lost money. If you invest money for the future, and in the future, you cannot buy the same goods and services with that block of money as you do today, you have lost money.
And that brings me to the following:
- One, going forward you cannot afford to be an average investor and make short-term emotional decisions on long-term investments. I suspect the margin for error of retirees and future retirees is going forward will be significantly less.
- Two, you have to understand and commit to the difference between a paper loss or gain and a realized loss or gain.
- Three, I would suggest your long-term average return will not be that important as your long-term real return.
Finally, it is acceptable to spend only a little time reviewing your quarterly investment report. I would suggest it would be a mistake to not spend considerable time thinking about your long-term financial future and the assumptions you are making.
Two last suggestions, if you have a financial advisor, have a conversation with he/she on your long-term assumptions and margin for error. If your financial advisor is not an independent fee-only CFP®, find a new financial advisor.