فصل 2 بخش 3

CHAPTER 2.3

MYTH 3: “OUR RETURNS? WHAT YOU SEE IS WHAT YOU GET”

Surprise, the returns reported by mutual funds aren’t actually earned by investors.

—JACK BOGLE, founder of Vanguard

Most people are familiar with the boilerplate disclaimer that past performance doesn’t guarantee future results. Far fewer are aware of how past performance numbers themselves can be misleading.

—“HOW FUNDS MASSAGE NUMBERS, LEGALLY,” Wall Street Journal, March 31, 2013

LIPSTICK ON A PIG

In 2002 Charles Schwab ran a clever TV ad where a typical Wall Street sales manager is giving a morning pep talk to his boiler room. “Tell your clients it’s red hot! En fuego! Just don’t mention the fundamentals—they stink.” He wraps up his morning sermon by dangling courtside tickets to the Knicks for the winning salesman and gives his final send-off: “Let’s put some lipstick on this pig!”

GET MY GOOD SIDE

In 1954 Darrell Huff authored a book entitled How to Lie with Statistics. He points to the “countless number of dodges which are used to fool rather than to inform.” Today the mutual fund industry has been able to use a tricky method to calculate and publish returns that are, as Jack Bogle says, “not actually earned by the investors.” But before we explain this masterful “sleight of pencil” magic, let’s first understand the illusion of average returns.

Below is a chart showing a hypothetical market that is up and down like a roller coaster. Up 50%, down 50%, up 50%, and down 50%. This produces an average return of 0%. And like you, I would expect that a 0% return would mean that I didn’t lose any money. And we would both be wrong!

As you can see by the chart, if you start with an actual dollar amount (let’s use $100,000), at the end of the four-year period, you are actually down $43,750, or 43.75%! You thought you were even, but instead you’re down 43.75%! Would you ever have guessed this? Now that you’re an insider, beware! Average returns have a built-in illusion, spinning a performance enhancement that doesn’t exist.

In a Fox Business article titled “Solving the Myth of Rate of Return,” Erik Krom explains how this discrepancy applies to the real world: “Another way to look at it is to review the Dow Jones since 1930. If you add up every number and divide it by 81 years, the return ‘averages’ 6.31%; however, if you do the math, you get an ‘actual’ return of 4.31%. Why is this so important? If you invested $1,000 back in 1930 at 6.31%, you would have $142,000, at 4.31% you would only have $30,000.”

THE SCALES ARE WEIGHTED

Now that we see that average returns aren’t a true representation of what we earn, sit back and relax because the grand illusion isn’t over yet. The math magicians on Wall Street have managed to calculate their returns to look even better. How so?

In short, when the mutual fund advertises a specific return, it’s not, as Jack Bogle says, “the return you actually earn.” Why? Because the returns you see in the brochure are known as time-weighted returns. Sounds complicated, but it’s not. (However, feel free to use that to look brilliant at your next cocktail party!) The mutual fund manager says if we have $1 at the beginning of the year and $1.20 at the end of the year, we are up 20%. “Fire up the marketing department and take out those full-page ads!” But in reality, investors rarely have all their money in the fund at the beginning of the year. We typically make contributions throughout the year—that is, out of every paycheck into our 401(k). And if we contribute more during times of the year when the fund is performing well (a common theme, we learned, as investors chase performance) and less during times when it’s not performing, we are going to have a much different return from what is advertised. So if we were to sit down at the end of the year and take into account the “real world” of making ongoing contributions and withdrawals, we would find out how much we really made (or lost). And this real-world approach is called the dollar-weighted return. Dollar-weighted returns are what we actually get to keep whereas time-weighted returns are what fund managers use to fuel advertising.

Jack Bogle has been a continual proponent of changing this rule. He believes that investors should see how much they actually earned (or lost) based on their own personal situation (contributions and withdrawals included). Sounds like common sense, right? But it’s no surprise why mutual funds are resistant. Bogle says: “We’ve compared returns earned by mutual fund investors—dollar-weighted returns—with the returns earned by the fund themselves, or time-weighted returns, and the investors seem to lag the fund themselves by three percent per year.” Wow! So if the fund advertises a 6% return, its investors achieved closer to 3%.

THE TRUTH AND THE SOLUTION

Average returns are like profile photos for online dating. They paint a better portrait than the reality! If you know the amount you started with in your investment and you know how much you have now, you can go to a website such as Moneychimp (www.moneychimp.com/calculator/discount_rate_calculator.htm), and it will show you exactly what the actual return is on your money over that period of time.

You must also remember that the returns reported by mutual funds are based on a theoretical person who invested all his money on Day 1. This just isn’t true for most so we can’t delude ourselves into believing that the glossy brochure returns are the same as what we have actually received in our account.

THE PATH IS CLEAR

Nobody said climbing a mountain would be easy. But it’s a heck of a lot easier when you have a machete called “truth” to hack away the lies and grant a clear view of the path ahead. As an insider, you are no longer flying blind.

You now know that stock-picking mutual funds don’t beat the market over any sustained period (especially after you account for fees and taxes).

You also know that fees do matter. And that by lowering your fees, you can get back as much as 60% to 70% of your future potential nest egg. How will this awesome truth impact your future?

And finally, you know that average returns don’t paint the real picture. Actual returns matter. And you now have the simple tools to calculate them.

Your journey to financial freedom has more than begun. You are hitting your stride, and the truths you have learned so far will separate you from being one of the “sheeple.” FLYING SOLO

As I have taught people these tools, I often notice that people feel as though they can no longer trust anyone. In a sense, they feel betrayed, as they become enlightened and start to understand the real rules of the game. They think they must now handle everything on their own and become an island unto themselves because “nobody can be trusted.” This just isn’t true. There are a number of incredible financial professionals who are full of integrity and committed to their clients’ futures. I have an amazing advisor whom I trust implicitly to act in my best interests, and together we review and manage my investments. Like you, I am insanely busy and don’t have the time or desire to spend my days managing the details of my portfolio. In reality, if done properly, a brief quarterly or twice-a-year review is all that is needed to go over your objectives and rebalance the portfolio.

So how do you know the difference between a salesman and a trusted advisor? Between a broker and a guide? Myth 4 will help us quickly determine if the person on the other side of the desk is working for you or the name on their company’s letterhead. As “Deep Throat” from the Watergate scandal said: “Follow the money. Always follow the money.”