Beware of mutual fund hype
Whenever I see advertisements for a mutual fund family, I am reminded of the famous saying by Garrison Keillor "Welcome to Lake Wobegon, where all the women are strong, all the men are good-looking, and all the children are above average." Similar to the children of Lake Wobegon, mutual fund families want you to believe that they all provide above average returns.
John Bogle is the founder of Vanguard funds and arguably the world's most famous proponent of low-cost investing. In a recent Financial Times article, Bogle does an excellent job of deconstructing the misleading numbers that are often provided by purveyors of financial products. Let's examine his logic:
Bogle first reminds us that a stock's value is NOT its current price. As Benjamin Graham first recognized in the 1920s, the value of a stock is represented by the discounted value of the company's future cash flow. He called this the "intrinsic value" of a company. At any particular time, the price of a share of stock may greatly exceed or be significantly less than its intrinsic value. However, in the long term, a stock's price will center around its intrinsic value.
Bogle next states that, due to the reduction of the stock dividends from the historic average annual rate of nearly 4.5 percent to the current rate of approximately 2 percent, nominal annual stock returns for the next decade will likely center around 7 percent instead of the historical 9.5 percent rate. Thus, if a 9.5 percent rate of return for future stock appreciation is used in financial projections, these projections will likely be significantly overstated.
As an example, if you invest $50,000 for 20 years, with a 9.5 percent nominal rate of return, $50,000 would become $307,080. However, if the nominal rate of return is 7 percent, in twenty years the nominal value of $50,000 would be $193,484.
A second "mistake" that Bogle notes is when projections show investment returns in nominal terms instead of their "real rate of return." The real rate of return is the nominal return return less the rate of inflation. If the expected nominal rate of return is 7 percent and inflation over the next 20 years is expected to match the historic long term annual rate of 3 percent, the real rate of return is 4 percent. Thus, using the same $50,000 investment over a 20 year period, the "spendable dollars" returned is only $109,556, a $200,000 reduction from the originally projected amount.
The third "mistake" is not including investment costs when considering total investment returns. Investment costs include fund operating expenses, trading costs, loads (including 12b-1 fees) and asset management expenses. These combined annual expenses can easily be 1.5 percent or more of your invested assets. If these fees are included, your annual real rate of return can be reduced to 2.5 percent or less. Including the reduction from investment fees, the $50,000 equity investment may only grows to a "spendable" $81,931 in 20 years.
All of the above calculations assume that the invested funds are held in a retirement account. If not, tax consequences could further reduce the investment returns.
After considering these dramatic reductions in projected investment returns, it may seem prudent to forgo investing in stocks. However, keeping money in a "safe" CD or money market fund will likely provide the historic long term real rate of return of -1 percent for these types of investments. With this real rate of return, these "safe" investments will provide a "spendable" $40,895 on the original $50,000 investment in 20 years. The "safe return" is approximately one-half of the return from the equity investment.
The message behind Bogle's article is to be wary of future performance projections portrayed by many mutual fund companies and other financial service organizations. By avoiding these three common mistakes, often ignored by investors and pension fund plans as well, you can identify more appropriate investment rates of return.