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Inflating Expectations

Have you ever read an article or seen a chart illustrating the "magic of compounding"?

What rate of return did the article illustrate?  Did the article also mention that historically, U.S. stocks have returned about 10%?  And then did the article or chart illustrate how even a modest savings plan would grow into a multi-million dollar portfolio?

Here's a typical example.  In "Stocks 102: The magic of compounding," MSN Money's New Investor Center describes an investor named Luke.  Luke saves only \$2,000 a year between the ages of 24 and 30 – \$12,000 in all – and then patiently and methodically achieves a "12% after-tax return" every year.  At age 65, he retires a millionaire (with \$1,074,968, to be exact).

Pretty exciting, isn't it?  How could it be any easier!  With your advisor's intelligent, steady management of your money, that's not expecting too much, is it?

Well, why not extend Luke's story further?  Assume Luke dies at the age of 65, and passes it down to his son, Luke Jr., who inherits it, doesn't touch it and lets it grow, before passing it on to his son Luke III, and so-on and so-on, so that the portfolio steadily grows at 12%/year for 220 years.  At that rate, the last Luke in the line of succession would have an astonishing \$441 trillion portfolio.  In just 220 short years, Luke's heir would rule the world with a golden fist – and be worth considerably more (in nominal terms, at least) than the present combined wealth of the whole world!

There's something wrong with this "magic," and it's not in the compounding.  The math isn't lying: that's what compounding Luke Sr.'s meager \$12K in savings at 12%/year for 220 years will get you.  What's "magical" about the story is the quixotic assumption of a 12% annualized return.  Regardless of the halcyon days of the past, expecting the equity markets – or your advisor – to deliver such generous annualized returns in the future, over the long term is grossly unrealistic.  (To understand why, read about the "equity risk premium").

Then why do so many financial services professionals do it?  Why do so many of them use illustrations like this to entice prospective clients?  It is sure to set up an ordinary investor for disappointment.

Believe it or not, many financial services professionals are sincere about their forecasts.  They have no familiarity with disaggregating past returns into fundamental components – like the dividend yield, price/earnings multiple expansion, and economic growth – nor do they have any clue what a reasonable forward-looking "equity risk premium" is.  So they simplistically assume that future returns will, on average, be as generous as past returns.

And besides, their expensive financial planning software – for which they pay upwards of \$1000/year in subscription fees – uses double-digit annual return projections.

Next: Dangerously Flawed Return Models