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Stingy Investor Tip Sheet

4 horsemen of apocalyptic returns

Jason Zweig's article in last weekend's WSJ chastised investors for their overly optimistic return expectations. Problem is, it seems to me, that even Zweig's low expectations may well be wildly optimistic.

But let's start with what got Jason all worked up. Evidently, "A nationwide survey last year found that investors expect the U.S. stock market to return an annual average of 13.7% over the next 10 years." Those are some mighty high expectations. But you never know. There's a small chance that a nice little bubble, or two, might get us there.

Anyway, Jason then tried to estimate "net net net" returns. (Not to be confused with Benjamin Graham's "Net Net" stocks.) Jason's "net net net" returns are returns after fees, taxes, and inflation.

Jason asked a few notable investors for their "net net net" return estimates. William Bernstein was the optimist at 4%, Laurence Siegel said 3%, John C. Bogle was keen on 2.5%, and Elroy Dimson was the pessimist at 0.5%. But the makeup of the portfolios in question wasn't clear. These estimates appear to be based on diversified stock and bond portfolios.

Nonetheless, these estimates seem high to me even for all stock portfolios. At least when it comes to the average investor. That's because the experts have likely assumed that investors will minimize fees and taxes (to the extent possible).

But instead of making projections, I like to look at historical returns and then factor in the 4 horsemen of the return apocalypse. I start with the annual returns for Canadian stocks as represented by the S&P/TSX Composite. I then factor in poor timing, fund fees, taxes, and inflation.

I assume that poor timing reduces returns by 3 percentage points a year which may be on the conservative side. Fund fees come in at 2.5% annually which is common for equity funds in Canada. I also assume that capital gains taxes of 23% are levied annually.

It is very important to note that investors can work to reduce all of these costs. (Inflation, the last horseman, is harder to deal with.)

How would an investor have fared when faced with such costs? The results are shown in the graphs below. Just be warned, they ain't pretty.

(click for larger version)

(click for larger version)

The moral of the story is to try to reduce fees, taxes, and poor timing.

Btw, real bears, like Eric Falkenstein, would add in a few more depressing factors.

Be careful, it's a risky world out there.

01/20/2010   11:30 PM EST   Permlink   save & shareMarkets

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