A myopic focus on investment returns is bad for your wealth

Compounded annual returns are the crack of the investment world. Wall Street is the pusher and investors are the addicts. Investment companies and investors focus on the annual return metric as the most important in a portfolio to the long term detriment of most investors. This myopic focus on annual returns is bad for investors’ wealth wether they are in the wealth building phase or the withdrawal phase of their investment lives. Lets look at how bad and expensive this unhealthy obsession can be.

First, lets look at the case of the investor building future wealth. In a world where an investor is purely rational, unemotional, and with good foresight of their future circumstances, then maximizing future wealth is probably the best portfolio metric to focus on. And that is what the investment world tries to shove down the throats of investors with a primary focus on annual returns for the ‘long run’. But we don’t live in that world. Investors, as human beings, are not rational much of the time, are emotional, and don’t always have control of their future circumstances. This leads to a lot of bad investment decisions. What evidence so we have of this? Actual investor returns. The chart below from JP Morgan’s Guide to Markets pretty much sums it up (the whole guide is well worth your time).

Stunning really. The average investor underperformed the benchmark 60/40 portfolio by 6.2% per year over the last 20 years! A good part of this underperformance is due to high fees. There’s been huge progress in the reduction of fees over the last 10 years but there are still some egregious examples. Check out some of the ones discussed here. A New York Life SP500 index fund with a 3% front end sales load and a 0.62% annual fee! This fund has over $2 billon dollars in assets. Or you can buy and Vanguard SP500 index fund for 0.09% per year. So much for rationality. The rest of the underperformance is due to behavioral factors such as performance chasing, panic selling during market downturns, etc… In my opinion, much of this poor behavior is due to the focus on annual returns over other metrics that describe risk adjusted returns such as sharpe ratio and maximum drawdowns. Shifting the focus of a portfolio to risk adjusted measures would cause different portfolio choices (see the many better risk choices I discuss here) and would help close the gap between investment performance and investor returns. The tough part of changing the focus to risk adjusted measures is that an investor could be choosing a portfolio with lower theoretical returns to increase their odds of sticking with the portfolio and thus increase their actual realized return. But this goes right in the face of another big, maybe the biggest, investor flaw – over confidence. Many investors look at theoretical investment returns and think “I’m not the average investor. I got this. I can stick with this portfolio during the bad times. I want to build the maximum total wealth before I retire.” despite the overwhelming evidence that this is unachievable for most. A switch to focus on risk adjusted returns is a tough sell to the person you’re looking at in the mirror and to even a good advisor trying to recommend the best portfolio for an investor.

Next, lets look at the more obvious case of the investor withdrawing from their portfolios every year. These investors are usually looking to maximize how much they can withdraw from their portfolios for a certain period of time, say a 30 year retirement period. This is the classic safe withdrawal rate (SWR) figure. Of course, this is related to annual returns in a big way but that is not the whole story. The volatility of the portfolio, especially during the first 10 years of the withdrawal period play a dominant role in determining the SWR. For example, if we look at the various portfolio’s SWRs I posted here we can see that the SWR for the benchmark 60/40 portfolio is 4.3%. Compare that to the Permanent Portfolio which had a return that was 0.5% per year lower than the 60/40 portfolio but with a lot lower volatility. Despite the lower returns, the Permanent Portfolio has an SWR of 5.6%, 30% higher than the 60/40 portfolio. Yet, the majority of the focus even for investors withdrawing from portfolios, mainly retirees, remains on annual returns despite the evidence that it leads to a significantly poorer retirement. For these sets of investors the decision should be a no-brainer since higher annual returns do not necessarily lead to higher withdrawals in retirement. I think this is slowly changing but there is still a long way to go.

In summary, annual returns should not be the primary focus for investors when considering portfolio allocations. This holds true whether an investor is in the wealth building phase or the withdrawal phase of their lives. A focus on risk adjusted returns would improve realized outcomes for all investors.