Getting real about returns

One of a financial consultant’s hardest jobs is to educate his clients about rates of return. Most people have very little idea about the rates of return on their investments. Worse, what inkling they have is always some far-out figure, something like 100% a year. Some people think it is normal. Others might even belittle the figure. “Hah, my uncle’s neighbour’s second cousin made 1,500% in seven days!”Perhaps this situation came about because of the massive publicity given to the stellar performances by world-class fund managers: Warren Buffett, John Templeton, George Soros and Peter Lynch. These four gentlemen each gave returns of above 14% per annum for over 10 years. And of course, all of us would hear — but never see any black and white — claims of even higher figures obtained by men in dark shadows. Let me now share the truth about rates of return from investments.Firstly, I must clarify that the rates of return that I’m talking about here are those from investments (stocks, unit trusts, mutual funds, and so on) and not from running a business. Investment is where you hand over your money to others and they manage the fund. This clarification is important as the return from business can go into the stratosphere. That is a topic for another article.Next, when looking at rates of return, you must look at them on a yearly basis. Fund managers are fond of showing the cumulative total returns instead of the annual figure. Why? Because the cumulative total returns figure always looks impressive. For example, Fund ABC gave a cumulative return of 47% after five years while Fund XYZ gave a cumulative return of 116% after 10 years. We have to admit the figures are certainly impressive. It’ll certainly make you sit up and take notice. But which fund performed better? It’s not easy for most investors to compare the two funds, as the periods are different. Actually, the annual compounded returns for both funds are the same — 8%. This is why you should always look at annual compounded return. It’s a more accurate measure and will enable you to compare different investments for the different periods.Third, and this is very important, the period must be for five years or longer. Why? Simple — rates of return can be distorted if you look at them over a short period. An investment can give a 30%, 40% or even 100% return in one year. It can do that for two or even three years. Why? Because the manager could have been lucky. He could have bought at the right time, and the market shot up immediately after that. As an example, any unit trust fund launched in 2005 and 2006 in Malaysia would have seen fabulous returns by mid-2007, probably above 20% per annum. Now it could be because the managers were good, smart and Capricorns to boot. But a more likely reason would be because Bursa Malaysia and the Kuala Lumpur Composite Index rose to an all-time high during the period.So, if you had based your decisions to invest in a fund on the stellar performance during the two years, you would have lost a significant amount of money today. We all know what has been happening in recent months — stock markets all over the world, including Bursa Malaysia, did a Humpty Dumpty and came tumbling down. So, if you look at the performance of the fund from 2007 to 2008, you would see a negative figure.That is why you must look at the performance over a period of five years or longer. You’ll get a more accurate picture. Very few funds can give stellar performances year in, year out. While they can do well for two or three years, the returns will eventually regress to the mean and come down. Here’s another example: There were two occasions when George Soros gave investors in his Quantum Fund returns of over 100% a year. But when averaged over 20 years, his return was 34%, which, to my knowledge, is still the highest of any fund manager in the world.Another important point is to know the range of probable returns that you are looking at. Without this information, you could be expecting too much out of the investment. Worse, you could be taken for a ride. For example, in the US, the real return (nominal return minus inflation rate) from 1871 to 1992 (a period of 120 years) for cash deposits was 1.9%, bonds 2.3% and stocks 6.5%. Of course, there were exceptional years in between. For example, stocks gave a return of 16.6% in the 1980s and 13% in the 1990s, the first double-digit returns seen over two consecutive decades.It is important to remember the 29% average annual return over 13 years achieved by Peter Lynch when he ran the Fidelity Magellan Fund. It is being quoted years after it happened. It is still being quoted because it is among the highest and the best performances of any fund manager in the world. Now if legends like Lynch gave “only” 29%, you cannot, and should not, expect more than that from ordinary managers. By the way, this figure applies to any investments.Actually, if you can get a consistent 10% to 15% a year, thank your lucky stars. If you can get a 10% return a year, you would double your money every seven years, which, we have to admit, is not a bad state of affairs. Finally, it is also critical to stick with the system once you have found one that works for you. As you know, the value of all investments fluctuates: It goes up, it comes down. If you have chosen well, the ups will be more than downs and, hopefully, the trend is upwards. This being the case, you should not let short-term price fluctuations affect your judgment. You should not panic and sell when the price has dropped. If all the reasons that made you buy the investment in the first place are still applicable, why sell? Stick to the plan. I have to mention this because people have sold out and lost money even when they were actually holding winners. After he retired at the age of 47, Lynch reported that, wonder of wonders, most of the investors in the Fidelity Magellan Fund lost money during his stellar run! They had bought into the fund when the market was doing well. Obviously, they paid a high price at that time as the market was peaking. Unfortunately, they panicked and sold out during the times the fund went south. Imagine that: the investors were actually holding a winner and yet, they lost money!So again, stick with a winning formula and ignore short-term price fluctuations. If you can do all this, you’ll be home free. You’ll be a happier, more contented person and more importantly, you’ll be growing your money in the process.   This article appeared in Issue 90 (February 2009) of Personal Money, the personal finance magazine published by The Edge Communications Sdn Bhd