How about a 100 percent return every month? That would certainly be desirable, but you wouldn't want to count on it. A more modest, but attainable return might be to beat the S&P 500 index, which over the past 90 years has averaged around 10 percent. Sounds reasonable enough, but it turns out that even this more modest goal, if not entirely unattainable, is a very big stretch. There are, however, a number of things you can do that will get you close to it.
Matching the Return of the S&P 500
The S&P 500 Index is a little less exclusive than the Dow Jones Industrial Average, but it's still a rarefied collection of highly successful companies like Apple, 3M, Advanced Micro Devices and Amazon. Even the companies you may not immediately recognize, like XL Group, are huge. The minimum market cap (the current total value of company stock) is $6.1 billion_._ These companies are the big winners. Outperforming an index based on their performances is going to be difficult. In fact, over a recent 10-year period, according to research reported in 2017 by MarketWatch, about 95 percent of fund managers failed to match the return of the S&P 500 Index. Also, remember that fund managers collect management fees from private investors; you're paying them. That gives them better than a half-point advantage.
But the biggest reason individual investors underperform the market is something that's not that difficult to remedy when you're investing for yourself. Another study, Dalbar's 2016 "Quantitive Analysis of Investor Behavior" also shows that over a 10-year period, the average individual investor underperforms the market by about half. But over 30 years, the underperformance gets worse: the returns of individual investors over the longer period are about one-third the return for the same period of the S&P 500. The primary reason for this underperformance, according to an analysis by NYU economists Malcolm Baker and Jeffrey Wurgler published in the Journal of Finance, is that investors invest on the basis of their emotions rather than relying on data. Put plainly, the research shows that when market returns are highest, individual investors are fearful, invest conservatively or stay in cash; when market returns are lowest, individual investors, filled with irrational exuberance, take the most chances – and pay the price.
How You Can Do Better
There are any number of things you can do to improve on returns beginning with the issue of investor sentiment. As Wurgler and Baker's research details, individual investors often oscillate between greed and fear. When the market's on fire late in the market cycle (shortly before the market turns South), they respond by buying on margin, going for riskier higher beta (more volatile) equities and will suffer greater losses when the market turns downward. When the bear market arrives, which sooner or later it always will, they panic and sell into cash, locking in their losses. When the next bull market arrives, having recently taken a drubbing, they stay in cash at the very time when market returns are highest.
Instead, you can resist being frightened into moving to cash in market downturns; stay invested. Avoid margin buying and glamour stocks; instead, buy well-diversified funds. Except in the first two years of a bull market, historically, value funds do better than growth funds, so be sure to keep value funds in your portfolio. When you research buying funds through Schwab®, Vanguard® or any other large online broker, both value and growth funds are clearly identified.
Analysis of more than 66,000 investor accounts undertaken by UC Professors of Economics Brad Barber and Terrance Odean shows that the more often an individual investor trades, the worse the return on investment. So, don't be a trader, which exposes you to short-term capital gain taxes and higher brokerage fees. Instead, buy and hold.
Research reported in 2017 by MarketWatch also shows that even professional fund managers aren't very good at picking individual stocks. About one in 20 did as well as an S&P 500 index fund. No harm in devoting some small portion of your portfolio to the companies you love, but in general, you'll do better being diversified. Among fund classes, index funds that simply try to replicate the performance of the broader market do better than actively managed funds where managers make stock choices.
Don't try to compete. Everyone has a friend who's just killing the market and will tell you about it, sometimes making you feel that you're somehow missing out. They're usually quieter when the market is killing them. Again, you're not trying to beat the market; you're trying to come as close as you can to matching it.
A related issue is the pitch that most funds make about their superior performance, with statistics to prove it, usually over one year to five years, occasionally longer. The truth is that buying funds on the basis of performance is a bad idea. Research sponsored by BAM Alliance, a community of over 135 independent wealth managers shows that if you select the top-performing funds and the worst performing funds in a given year, after ten years the returns of the two groups will be about equal.
Instead, concentrate on lowering investment fees. You can do that by buying and selling infrequently and buying the lowest cost funds available. As of this writing, the two firms with the lowest management fees are Schwab and Vanguard. But things change, so check before you buy.
To return to the question of what a desirable stock portfolio rate of return is, it would seem that if you, as an individual investor can achieve returns on your investments that beat the average investor's long-term average of around 5.5 percent, you're doing pretty well. By concentrating your investments on index funds, you can come close to matching their returns. If the long-term market average is 10 percent, perhaps you can achieve a long-term return of 8 or 9 percent, which is very desirable.
Video of the Day
- Investopedia: What Is the Average Annual Return for the S&P 500?
- Morningstar: U.S. Fund Fee Study--Average Fund Fees Paid by Investors Continued to Decline in 2016
- CFA Institute:Luck versus Skill in the Cross-Section of Mutual Fund Returns (Digest Summary)
- MarketWatch:This Is How Many Fund Managers Actually Beat Index Funds
- Dalbar's: Quantitative Analysis of Investor Behavior, 2015
- NYU Stern: Investor Sentiment and the Cross-Section of Stock Returns
- BAM: Persistence Among Active Managers Remains Elusive
- SSRN:The Behavior of Individual Investors
- Duncan Smith/Photodisc/Getty Images