Active investing is the only way to superior returns

The field of play

But, is it worth the effort?

Everyone tells us that it is well-nigh on impossible to do better than S&P 500 returns and that, in any event, it’s an awful lot of work for an iffy proposition. In this post I will explore the question of whether it is worth the effort.

This post does not discuss the chances of doing better. It’s solely focused on what’s to be gained if you succeed.

A rough guestimate for future S&P 500 returns

In 2013, at 83 years of age, John Bogle, the founder and former chief executive of the Vanguard Group of Mutual Funds, gave an interview to the Toronto Globe and Mail newspaper in promotion of his new book, The Clash of Cultures: Investment vs. Speculation. He said: “In the coming decade, if equities do 7 per cent a year – a reasonable enough number – and bonds will be doing less than this because interest rates are so much lower, say 3 per cent a year – and you have 60 per cent in equities and 40 per cent in bonds, that’s 5.5 per cent. Then you take out costs, call it 1 per cent, that’s 4.5 per cent. They never talk about costs – they talk about market return. Which is just stupid to think you can capture the market return [after costs]. Nobody does!”

In the last 50 years the S&P 500 has produced a compounded annualized total return of 10.8%. John Bogle’s 7% is a good starting point even in 2020. There may be some costs and other vagaries. Let’s be conservative. Looking forward over the next 20 or 30 years, a good rough guestimate for present purposes would be that equities will produce a compounded total return of some 6% per annum.

Satisfactory investment results

My supposition is that an investor buying and holding a super low cost S&P 500 index fund or ETF would achieve a return over the next 20 to 30 years of some 6% compounded annually. If the investor puts all their retirement savings into that fund, i.e. be 100% invested in equities, on that assumption, their return should be 6%. If they have 60% in the equity fund and 40% in bonds, they won’t achieve Bogle’s 4.5% because bond yields are lower today.

In The Intelligent Investor Ben Graham wrote: “To achieve satisfactory investment results is easier than most people realize; to achieve superior results is harder than it looks.” (Graham, 1973) p. 287 (emphasis added). I would call the 6% return a ‘satisfactory’ return and it is easily achieved by investing in an index mutual fund or ETF.

Even so, the index investor must be prepared to endure the ups and downs (volatility) of the stock market. The rub is volatility. Ben Graham explains: “In any case the investor may as well resign himself in advance to the probability rather than the mere possibility that most of his holdings will advance, say 50% or more from their low point and decline the equivalent one-third or more from their high point at various periods in the next five years.” (Graham, 1973) p. 101 (emphasis added). It may be easier for a true passive index investor to endure volatility because the investment doesn’t need to be monitored closely. The fact is that all investors in equities must endure volatility. In truth, as discussed elsewhere in the Motherlode, volatility is the friend of the active investor. It presents opportunities.

Superior results are hard to come by

Ben Graham tells us that to achieve ‘superior’ results is harder than it looks. To my way of thinking, ‘superior’ results mean achieving a significantly higher return than ‘satisfactory’ returns. One should never be trying to beat the market. See my post here on how this can lead to risk seeking behavior. So, what’s to be gained? My conclusion is that if you can achieve a ‘superior’ return you can potentially more than double your retirement income.

It can be done by ordinary individual investors. Since I started saving for retirement in 1972 I have achieved a compounded total return on our family savings of 13.41%. This includes time in bonds and treasury bills. This performance compares with an S&P 500 Index compounded rate of return with full dividend reinvestment of 10.36% over the same time frame. During this period the average rate of inflation was 3.81%. So, this is over almost 50 years. I am simply an individual investor.

What sort of difference can 2% make?

Let’s say that with a reasonable effort one could, over a lifetime, earn 2% more than the ‘satisfactory’ return from an index fund. Would it be worth the effort? 

I have done some simple calculations using 6% as a base rate. If you can increase your total return on your retirement savings by 2%, your capital on retirement will be some 75% higher, not 33% higher. This is because of the magic of compounding. Instead of having, say $1,000,000 retirement savings you would have $1,750,000.

If you continued to achieve superior returns of 8% after retirement, you would have an income of more than twice that achieved with satisfactory returns after retirement. 

How much effort is required?

I can only speak to my own experience. I had a busy law practice and full family life. I am retired now. While working, I spent one half day on the weekends occupied with our investments and a couple of hours sprinkled in bits and pieces at other times during the week. In a speech given in 1974, Ben Graham remarked that investing did not require genius: “What it needs is, first, reasonably good intelligence; second, sound principles of operation; third, and most important, firmness of character.” The Motherlode discusses ‘sound principles of operation’ and ‘firmness of character’.

Bottom line

What all this means is that an added 2% return can make a huge difference in your retirement income. These are very rough figures. It’s all a function of compounding. My point, very simply, is that a superior return is worth working hard to achieve.

You can change the assumptions. You can lower expected returns or increase them. If you can achieve ‘superior returns’, it really is worth the effort you put into it. And active investing is the only way to superior returns. Indexing caps you at satisfactory returns.

Readers wishing to dig deeper might take a look at the Motherlode Part 1: The Field of Play

The Chapters in Part 1: The Field of Play are:

1. Stocks Beat Every Other Asset Class
2. Is it Worth it?
3. Is it Possible?
4. Risk and Uncertainty
5. Efficient Market Hypothesis
6. Inefficient Market Hypothesis
7. Volatility
8. The Economy and the Stock Market – Cycles and Trends

Want to dig deeper into the principles behind successful investing?

Click here for the Motherlode – introduction

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