Edith and the Headwinds She Faces
If you swallow a toad when the market opens, you will encounter nothing more disgusting the rest of the day.
—Paraphrase of a remark attributed to the famous misanthrope, Nicolas de Chamfort (1741–1794)13
John Bogle, founder of The Vanguard Group and one of the wisest men in the business, once gave a speech titled, Don't Count On It! The Perils of Numeracy, in which he said, in part:
“My thesis is that today, in our society, in economics, and in finance, we place too much trust in numbers. Numbers are not reality. At best, they're a pale reflection of reality. At worst, they're a gross distortion of the truths we seek to measure.”14 [emphasis in the original]
Oddly, nearly 20 years earlier, the eminent ecologist, Garrett Hardin,15 had bemoaned our lack of numeracy:
“[L]iteracy is not enough … we also need numeracy, the ability to handle numbers and the habit of demanding them. A merely literate person may raise no question when a journalist speaks of ‘the inexhaustible wealth of the sea,’ or ‘the infinite resources of the earth.’ The numerate person, by contrast, asks for figures and rates.”16
Far be it from me to choose sides between such towering eminences grises—let's just say that they are both right. Bogle is surely correct: Numerate investors have focused so hard on the gross return expectations developed by modern portfolio theorists that we have frequently missed the forest for the trees. But Hardin is also right: Frustration with investment results is all too often the result of innumeracy;, that is, our failure to appreciate the true import of the numbers we are looking at. The long and short of it is that investors who hope to preserve—much less grow!—their capital are faced with enormous challenges.
Let's follow Bogle's calculations,17 as set forth in his speech, and see where they lead. Imagine an investor—we'll call her Edith—who at age 25 is the happy recipient of a $10 million inheritance from her grandmother.
Aside from being a very fortunate young lady, Edith is also no fool, having studied modern portfolio theory at Vassar. Edith decides that she would like to do the same for her own grandchildren one day—leave them a handsome inheritance. Noting that the long-term return on stocks is 11.3 percent,18 Edith asks her family's longtime advisor, Mildew Trust Co., to invest the entire $10 million in stocks. A simple calculation tells Edith that, 50 years hence, when she is 75, she should be able to pass on to her grandchildren a trust fund worth a cool $2.8 billion. This should certainly earn her the distinction of Everyone's Favorite Grandma.
Unfortunately, Edith forgot a few things in her eagerness to generate terrific total returns and become Everyone's Favorite Grandma. Let's observe what is actually far more likely to happen to that wonderful sum of $2.8 billion.
The First Thing Edith Forgot: Variance Drain
Edith calculated her compound annual return on her trusty financial calculator, but she simply projected an 11.3 percent straight-line return. Alas, such returns don't happen in the messy real world of the capital markets.19
In other words, Edith isn't going to get an 11.3 percent return every year for 50 years. Sometimes her return will be better, sometimes worse. Specifically, assuming that her returns exhibit a standard deviation (S.D.) of 16, then two-thirds of the time her return is likely to fall between +27.3 percent and −4.7 percent. One-third of the time her return will be higher or lower than that.
And this variability in the return series—the price volatility that is inherent in owning equity securities—will profoundly reduce her terminal net wealth. Indeed, the greater the volatility of the returns the lower will be her terminal wealth, assuming that we keep the annual compound return constant.
If we assume, as we have, an average variability of 16 percent (roughly the S.D. of U.S. large-company stock returns over Bogle's measuring period), we find that the best Edith can hope for after 50 years of compounding is about $1.5 billion.20 (Not to be an alarmist, but if the S.D. of Edith's returns turns out to be closer to 20 percent, as has been the case over longer periods of time with U.S. large-cap stocks, Edith's terminal wealth will be reduced further, to $1 billion. But let's hope for the best.)
We'll forgive Edith for this lapse—her grandchildren will still be billionaires—but variance drain is an issue to which too many investors (and all-too-many investment professionals!) don't pay enough attention.21
The Second Thing Edith Forgot: Inflation
As Bogle points out, over the past 50 years inflation has averaged 4.2 percent.22 Therefore, the real rate of return on U.S. stocks is not 11.3 percent, but only 7.1 percent. Surely Edith doesn't want to leave her grandchildren worthless, inflated dollars, but real buying power. Alas, then, her original dream of leaving several billion dollars to her grandchildren has turned out to be a fantasy. The real value of her legacy is “only” $182 million. Even so, her grandchildren will be centimillionaires.
The Third Thing Edith Forgot: Investment Costs
Stock market indexes produce gross returns, but investors generate only returns that are net of the costs of obtaining them. These costs include investment management fees, brokerage commissions, spreads between bid and asked prices, and (something many investors overlook) market impact.23 Bogle estimates that such costs come to at least 2 percent per year.24 Although we are confident that Mildew Trust Co. could run that number up considerably higher, we'll settle for Bogle's number. Net of investment costs, therefore, Edith's return is likely to be about 5.1 percent. This brings her future grandchildren's inheritance down to $67 million. Well, even so, it's nothing to sniff at.
The Fourth Thing Edith Forgot: Taxes
If Edith had been born into life as a pension plan or charitable endowment, she could obtain her investment returns without worrying about having Uncle Sam as her investment partner. But as a taxpaying future grandmother, Edith must pay ordinary income tax rates on interest, dividends, and short-term capital gains, and capital gains tax rates on long-term gains. Bogle estimates that, over time, taxes eat up about 2 percent per year of investment returns.25 This reduces Edith's annual returns to 3.1 percent and her grandchildren's inheritance to $25 million. A far cry from $2.8 billion, to be sure, but still better than a poke in the eye with a sharp stick.
The Fifth Thing Edith Forgot: Spending
A girl's gotta live somehow, of course, and though we don't know exactly how much of Edith's inheritance she will spend each year, we have some pretty good yardsticks to use for comparison purposes. The Internal Revenue Service, for example, requires private charitable foundations to spend 5 percent of their endowment values (on average), and many non-profit organizations also spend roughly 4 percent to 6 percent of their average endowment values each year.
Of course, these are largely26 tax-exempt investors. But we also have the Uniform Principal and Income Act, which permits trustees to manage trusts as “unitrusts,” adopting total return investment strategies and simply paying out to the income beneficiary a certain percentage of the value of the trust corpus each year. That percentage is fixed at 4 percent. Indeed, if a trustee wishes to pay out more or less than 4 percent per year it must seek court approval to do so. We harbor our private doubts about whether Mildew Trust Co. will spring for the unitrust idea, but we'll give them the benefit of the doubt and assume that they do. Her spending brings Edith's annual return down to—oops.
Edith's return has now moved into negative territory: −0.9 percent per year. In other words, instead of watching happily as her $10 million grows to $2.8 billion over the next half century, Edith will be lucky to wind up with a bit over $3 million, roughly 1/10 of 1 percent of what she hoped to get. Instead of Everyone's Favorite Grandma, Edith is likely to be remembered as That Old Witch Who *% ##@! Away Our Inheritance (this is a family publication).